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2012-10562

  • Federal Register, Volume 77 Issue 100 (Wednesday, May 23, 2012)[Federal Register Volume 77, Number 100 (Wednesday, May 23, 2012)]

    [Rules and Regulations]

    [Pages 30596-30764]

    From the Federal Register Online via the Government Printing Office [www.gpo.gov]

    [FR Doc No: 2012-10562]

    [[Page 30595]]

    Vol. 77

    Wednesday,

    No. 100

    May 23, 2012

    Part II

    Commodity Futures Trading Commission

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    17 CFR Part 1

    Securities and Exchange Commission

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    17 CFR Part 240

    Further Definition of ``Swap Dealer,'' ``Security-Based Swap Dealer,''

    ``Major Swap Participant,'' ``Major Security-Based Swap Participant''

    and ``Eligible Contract Participant;'' Final Rules

    Federal Register / Vol. 77, No. 100 / Wednesday, May 23, 2012 / Rules

    and Regulations

    [[Page 30596]]

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    COMMODITY FUTURES TRADING COMMISSION

    17 CFR Part 1

    RIN 3038-AD06

    SECURITIES AND EXCHANGE COMMISSION

    17 CFR Part 240

    [Release No. 34-66868; File No. S7-39-10]

    RIN 3235-AK65

    Further Definition of ``Swap Dealer,'' ``Security-Based Swap

    Dealer,'' ``Major Swap Participant,'' ``Major Security-Based Swap

    Participant'' and ``Eligible Contract Participant''

    AGENCY: Commodity Futures Trading Commission; Securities and Exchange

    Commission.

    ACTION: Joint final rule; joint interim final rule; interpretations.

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    SUMMARY: In accordance with the Dodd-Frank Wall Street Reform and

    Consumer Protection Act of 2010 (``Dodd-Frank Act''), the Commodity

    Futures Trading Commission (``CFTC'') and the Securities and Exchange

    Commission (``SEC'') (collectively, the ``Commissions''), in

    consultation with the Board of Governors of the Federal Reserve System

    (``Board''), are adopting new rules and interpretive guidance under the

    Commodity Exchange Act (``CEA''), and the Securities Exchange Act of

    1934 (``Exchange Act''), to further define the terms ``swap dealer,''

    ``security-based swap dealer,'' ``major swap participant,'' ``major

    security-based swap participant,'' and ``eligible contract

    participant.''

    DATES: Effective date. The effective date for this joint final rule and

    joint interim final rule: July 23, 2012, except for CFTC regulations at

    17 CFR 1.3(m)(5) and (6), which are effective December 31, 2012.

    Comment date. The comment period for the interim final rule (CFTC

    regulation at 17 CFR 1.3(ggg)(6)(iii)) will close July 23, 2012.

    Compliance date. Compliance with the element of the CFTC regulation

    at 17 CFR 1.3(m)(8)(iii) requiring that a commodity pool be formed by a

    registered CPO shall be required with respect to a commodity pool

    formed on or after December 31, 2012 for any person seeking to rely on

    such regulation; compliance with such element shall not be required

    with respect to a commodity pool formed prior to December 31, 2012.

    FOR FURTHER INFORMATION CONTACT:

    CFTC: Jeffrey P. Burns, Assistant General Counsel, at 202- 418-

    5101, jburns@cftc.gov, Mark Fajfar, Assistant General Counsel, at 202-

    418-6636, mfajfar@cftc.gov, Julian E. Hammar, Assistant General

    Counsel, at 202-418-5118, jhammar@cftc.gov, or David E. Aron, Counsel,

    at 202-418-6621, daron@cftc.gov, Office of General Counsel; Gary

    Barnett, Director, at 202-418-5977, gbarnett@cftc.gov, or Frank

    Fisanich, Deputy Director, at 202-418-5949, ffisanich@cftc.gov,

    Division of Swap Dealer and Intermediary Oversight,Commodity Futures

    Trading Commission, Three Lafayette Centre, 1155 21st Street NW.,

    Washington, DC 20581;

    SEC: Joshua Kans, Senior Special Counsel, Richard Grant, Special

    Counsel, or Richard Gabbert, Attorney Advisor, at 202-551-5550,

    Division of Trading and Markets, Securities and Exchange Commission,

    100 F Street NE., Washington, DC 20549-7010.

    SUPPLEMENTARY INFORMATION:

    I. Background

    On July 21, 2010, President Obama signed the Dodd-Frank Act into

    law.\1\ Title VII of the Dodd-Frank Act established a statutory

    framework to reduce risk, increase transparency, and promote market

    integrity within the financial system by, among other things: (i)

    providing for the registration and regulation of swap dealers and major

    swap participants; (ii) imposing clearing and trade execution

    requirements on standardized derivative products; (iii) creating

    recordkeeping and real-time reporting regimes; and (iv) enhancing the

    Commissions' rulemaking and enforcement authorities with respect to all

    registered entities and intermediaries subject to the Commissions'

    oversight.

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    \1\ See Dodd-Frank Wall Street Reform and Consumer Protection

    Act, Public Law 111-203, 124 Stat. 1376 (2010). The text of the

    Dodd-Frank Act may be accessed at http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm.

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    The Dodd-Frank Act particularly provides that the CFTC will

    regulate ``swaps,'' and that the SEC will regulate ``security-based

    swaps.'' The Dodd-Frank Act also adds definitions of the terms ``swap

    dealer,'' ``security-based swap dealer,'' ``major swap participant,''

    ``major security-based swap participant'' and ``eligible contract

    participant'' to the CEA and Exchange Act.\2\ Section 712(d)(1) of the

    Dodd-Frank Act further directs the CFTC and the SEC, in consultation

    with the Board, jointly to further define those terms, among others.\3\

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    \2\ See Dodd-Frank Act sections 721 and 761. Sections 721(b)(2)

    and 761(b)(2) also provide that the CFTC and SEC may by rule further

    define any other term included in an amendment made by Title VII to

    the CEA or the Exchange Act, respectively.

    \3\ In addition, section 712(d)(1) directs the CFTC and SEC, in

    consultation with the Board, jointly to further define the terms

    ``swap,'' ``security-based swap,'' and ``security-based swap

    agreement.'' These further definitions are the subject of a separate

    rulemaking by the Commissions. See CFTC and SEC, Notice of Proposed

    Joint Rulemaking, Further Definition of ``Swap,'' ``Security-Based

    Swap,'' and ``Security-Based Swap Agreement''; Mixed Swaps;

    Security-Based Swap Agreement Recordkeeping, 76 FR 29818 (May 23,

    2011) (``Product Definitions Proposal''). Section 712(d)(2)(A), in

    turn, provides that the Commissions shall jointly adopt such other

    rules regarding the definitions set forth in section 712(d)(1) as

    they ``determine are necessary and appropriate, in the public

    interest, and for the protection of investors.''

    In addition, section 721(c) of the Dodd-Frank Act requires the

    CFTC to adopt a rule to further define the terms ``swap dealer,''

    ``major swap participant,'' and ``eligible contract participant''

    for the purpose of including transactions and entities that have

    been structured to evade Title VII. Also, section 761(b) of the

    Dodd-Frank Act permits the SEC to adopt a rule to further define the

    terms ``security-based swap dealer,'' ``major security-based swap

    participant,'' and ``eligible contract participant,'' with regard to

    security-based swaps, for the purpose of including transactions and

    entities that have been structured to evade Title VII.

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    In December 2010, the Commissions proposed rules and

    interpretations to further define the meaning of the terms ``swap

    dealer,'' ``security-based swap dealer,'' ``major swap participant,''

    ``major security-based swap participant,'' and ``eligible contract

    participant.'' \4\ The Commissions received approximately 968 written

    comments in response to the Proposing Release.\5\ In addition, the

    Staffs of the Commissions participated in approximately 114 meetings

    with market participants and other members of the public about the

    Proposing Release,\6\ and the Commissions held a

    [[Page 30597]]

    Joint Public Roundtable on the proposed dealer and major participant

    definitions.\7\ After considering the comments received, the

    Commissions are adopting final rules and interpretations to further

    define these terms.

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    \4\ See CFTC and SEC, Notice of Proposed Joint Rulemaking:

    Further Definition of ``Swap Dealer,'' ``Security-Based Swap

    Dealer,'' ``Major Swap Participant,'' ``Major Security-Based Swap

    Participant'' and ``Eligible Contract Participant,'' Securities

    Exchange Act Release No. 63452, 75 FR 80174 (Dec. 21, 2010)

    (``Proposing Release'').

    Prior to issuing the Proposing Release, the Commissions issued a

    joint Advance Notice of Proposed Rulemaking (``ANPRM'') requesting

    public comment regarding the definitions of the terms ``swap,''

    ``security-based swap,'' ``security-based swap agreement,'' ``swap

    dealer,'' ``security-based swap dealer,'' ``major swap

    participant,'' ``major security-based swap participant,'' and

    ``eligible contract participant.'' See CFTC and SEC, Advance Notice

    of Proposed Joint Rulemaking: Definitions Contained in Title VII of

    Dodd-Frank Wall Street Reform and Consumer Protection Act,

    Securities Exchange Act Release No. 62717, 75 FR 51429 (Aug. 20,

    2010). The Proposing Release and these final rules both reflect

    comments received in response to the ANPRM.

    \5\ Comment letters received in response to the Proposing

    Release may be found on the Commissions' Web sites at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=933 and at

    http://www.sec.gov/comments/s7-39-10/s73910.shtml.

    \6\ Summaries of these staff meetings may be found on the

    Commissions' Web sites at http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_2_Definitions/index.htm and http://www.sec.gov/comments/s7-39-10/s73910.shtml#meetings.

    \7\ A transcript of the roundtable discussion and public

    comments received with respect to the roundtable may be found on the

    CFTC's Web site at http://www.cftc.gov/PressRoom/Events/opaevent_cftcsecstaff061611.

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    II. Definitions of ``Swap Dealer'' and ``Security-Based Swap Dealer''

    The Dodd-Frank Act definitions of the terms ``swap dealer'' and

    ``security-based swap dealer'' focus on whether a person engages in

    particular types of activities involving swaps or security-based

    swaps.\8\ Persons that meet either of those definitions are subject to

    statutory requirements related to, among other things, registration,

    margin, capital and business conduct.\9\

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    \8\ See section 721 of the Dodd-Frank Act (adding Section 1a(49)

    of the CEA, 7 U.S.C. 1a(49), to define ``swap dealer'') and section

    761 of the Dodd-Frank Act (adding Section 3(a)(71) of the Exchange

    Act, 15 U.S.C. 78c(a)(71), to define ``security-based swap

    dealer'').

    \9\ The Dodd-Frank Act excludes from the Exchange Act definition

    of ``dealer'' persons who engage in security-based swaps with

    eligible contract participants. See section 3(a)(5) of the Exchange

    Act, 15 U.S.C. 78c(a)(5), as amended by section 761(a)(1) of the

    Dodd-Frank Act.

    The Dodd-Frank Act does not include comparable amendments for

    persons who act as brokers in swaps and security-based swaps.

    Because security-based swaps, as defined in section 3(a)(68) of the

    Exchange Act, are included in the Exchange Act section 3(a)(10)

    definition of ``security,'' persons who act as brokers in connection

    with security-based swaps must, absent an exception or exemption,

    register with the SEC as a broker pursuant to Exchange Act section

    15(a), and comply with the Exchange Act's requirements applicable to

    brokers.

    In mid-2011, the SEC issued temporary exemptions under the

    Exchange Act in connection with the revision of the ``security''

    definition to encompass security-based swaps. Among other aspects,

    these temporary exemptions extended to certain broker activities

    involving security-based swaps. See ``Order Granting Temporary

    Exemptions under the Securities Exchange Act of 1934 in Connection

    with the Pending Revision of the Definition of ``Security'' to

    Encompass Security-Based Swaps, and Request for Comment,''

    Securities Exchange Act Release No. 64795 (Jul. 1, 2011), 76 FR

    39927, 39939 (Jul. 7, 2011) (addressing availability of exemption to

    registration requirement for securities brokers).

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    The CEA and Exchange Act definitions in general encompass persons

    that engage in any of the following types of activity:

    (i) Holding oneself out as a dealer in swaps or security-based

    swaps,

    (ii) making a market in swaps or security-based swaps,

    (iii) regularly entering into swaps or security-based swaps with

    counterparties as an ordinary course of business for one's own account,

    or

    (iv) engaging in any activity causing oneself to be commonly known

    in the trade as a dealer or market maker in swaps or security-based

    swaps.\10\

    \10\ See CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A); Exchange Act

    section 3(a)(71)(A), 15 U.S.C. 78c(a)(71)(A).

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    These dealer activities are enumerated in the CEA and Exchange Act in

    the disjunctive, in that a person that engages in any one of these

    activities is a swap dealer under the CEA or security-based swap dealer

    under the Exchange Act, even if such person does not engage in one or

    more of the other identified activities.

    At the same time, the statutory dealer definitions provide

    exceptions for a person that enters into swaps or security-based swaps

    for the person's own account, either individually or in a fiduciary

    capacity, but not as a part of a ``regular business.'' \11\ The Dodd-

    Frank Act also instructs the Commissions to exempt from designation as

    a dealer a person that ``engages in a de minimis quantity of [swap or

    security-based swap] dealing in connection with transactions with or on

    behalf of its customers.'' \12\ Moreover, the definition of ``swap

    dealer'' (but not the definition of ``security-based swap dealer'')

    provides that an insured depository institution is not to be considered

    a swap dealer ``to the extent it offers to enter into a swap with a

    customer in connection with originating a loan with that customer.''

    \13\ The statutory definitions further provide that a person may be

    designated as a dealer for one or more types, classes or categories of

    swaps or security-based swaps, or activities without being designated a

    dealer for other types, classes or categories or activities.\14\

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    \11\ See CEA section 1a(49)(C), 7 U.S.C. 1a(49)(C); Exchange Act

    section 3(a)(71)(C), 15 U.S.C. 78c(a)(71)(C).

    \12\ See CEA section 1a(49)(D), 7 U.S.C. 1a(49)(D); Exchange Act

    section 3(a)(71)(D), 15 U.S.C. 78c(a)(71)(D).

    \13\ See CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A).

    \14\ See CEA section 1a(49)(B), 7 U.S.C. 1a(49)(B); Exchange Act

    section 3(a)(71)(B), 15 U.S.C. 78c(a)(71)(B).

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    In the Proposing Release, the Commissions proposed rules to

    identify the activity that would cause a person to be a dealer,\15\ to

    implement the exception for de minimis dealing activity,\16\ to

    implement the exception from the swap dealer definition in connection

    with the origination of loans by insured depository institutions,\17\

    and to provide for the limited purpose designation of dealers.\18\ The

    release also set forth proposed interpretive guidance related to the

    definitions.

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    \15\ See proposed CFTC Regulation Sec. 1.3(ggg)(1); proposed

    Exchange Act rule 3a71-1(a), (b).

    \16\ See proposed CFTC Regulation Sec. 1.3(ggg)(4); proposed

    Exchange Act rule 3a71-2.

    \17\ See proposed CFTC Regulation Sec. 1.3(ggg)(5).

    \18\ See proposed CFTC Regulation Sec. 1.3(ggg)(3); proposed

    Exchange Act rule 3a71-1(c).

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    After considering the comments received, the Commissions are

    adopting final rules and interpretations to further define the terms

    ``swap dealer'' and ``security-based swap dealer.'' In this Adopting

    Release, we particularly address: (i) The general analysis for

    identifying dealing activity involving swaps and security-based swaps;

    (ii) the exclusion from the ``swap dealer'' definition in connection

    with the origination of loans by insured depository institutions; (iii)

    the application of the dealer analysis to inter-affiliate swaps and

    security-based swaps; (iv) the application of the de minimis exception

    from the dealer definitions; and (v) the limited designation of swap

    dealers and security-based swap dealers.

    A. General Considerations for the Dealer Analysis

    1. Proposed Approach

    The proposed rules to define the activities that would lead a

    person to be a ``swap dealer'' and ``security-based swap dealer'' were

    based closely on the corresponding language of the statutory

    definitions.\19\ The Proposing Release further noted that the Dodd-

    Frank Act defined the terms ``swap dealer'' and ``security-based swap

    dealer'' in a functional manner, and stated that those statutory

    definitions should not be interpreted in a constrained, overly

    technical or rigid manner, particularly given the diversity of the swap

    and security-based swap markets. The Proposing Release also identified

    potential distinguishing characteristics of swap dealers and security-

    based swap dealers based on the functional role that dealers fulfill in

    the swap and security-based swap markets, such as: dealers tend to

    accommodate demand from other parties; dealers generally are available

    to enter into swaps or security-based swaps to facilitate other

    parties' interest; dealers tend not to request that other parties

    propose the terms of swaps or security-based swaps, but instead tend to

    enter into those instruments on their own standard terms or on terms

    they arrange in response to other parties' interest; and dealers tend

    to be able to arrange customized terms for

    [[Page 30598]]

    swaps or security-based swaps upon request, or to create new types of

    swaps or security-based swaps at the dealer's own initiative.\20\

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    \19\ See CFTC Regulation Sec. 1.3(ggg); Exchange Act rule 3a71-

    1(a), (b).

    \20\ Proposing Release, 75 FR at 80176.

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    The proposal recognized that the principles for identifying dealing

    activity involving swaps can differ from principles for identifying

    dealing activity involving security-based swaps, in part due to

    differences in how those instruments are used.\21\

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    \21\ Id.

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    a. ``Swap Dealer'' Activity

    Consistent with the statutory definition, the proposed rule stated

    that the term ``swap dealer'' includes a person that ``regularly enters

    into swaps with counterparties as an ordinary course of business for

    its own account,'' but also that ``the term swap dealer does not

    include a person that enters into swaps for such person's own account,

    either individually or in a fiduciary capacity, but not as a part of a

    regular business.'' The Proposing Release stated that these two

    provisions should be read in combination with each other, and explained

    that the difference between the two provisions is whether or not the

    person enters into swaps as a part of, or as an ordinary course of, a

    ``regular business.'' Thus, the Proposing Release equated the phrases

    ``ordinary course of business'' and ``regular business.'' The Proposing

    Release also stated that persons who enter into swaps as a part of a

    ``regular business'' are those persons whose function is to accommodate

    demand for swaps from other parties and enter into swaps in response to

    interest expressed by other parties. Such persons would be swap

    dealers.\22\ Conversely, the Proposing Release said that persons who do

    not fulfill this function in connection with swaps should not be deemed

    to enter into swaps as part of a ``regular business,'' and thus would

    not likely be swap dealers.\23\

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    \22\ In addition, the Proposing Release explained that (in

    general, and not specifically limited to the provisions relating to

    entering into swaps as part of a ``regular business'') the proposed

    swap dealer definition does not depend on whether a person's

    activity as a swap dealer is the person's sole or predominant

    business (other than through the de minimis exception discussed

    below).

    \23\ See Proposing Release, 75 FR at 80177.

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    In addition, the Proposing Release noted that the nature of swaps

    precludes importing concepts used to identify dealers in other areas.

    The Proposing Release explained that because swaps are typically not

    bought and sold, concepts such as whether a person buys and sells

    swaps, makes a two-sided market in swaps, or trades within a bid/offer

    spread cannot necessarily be used to determine if the person is a swap

    dealer, even if such concepts are useful in determining whether a

    person is a dealer in other financial instruments.\24\

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    \24\ See id. at 80176-77.

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    The Proposing Release further stated that swap dealers can be

    identified through their relationships with counterparties, explaining

    that swap dealers tend to enter into swaps with more counterparties

    than do non-dealers, and in some markets, non-dealers tend to

    constitute a large portion of swap dealers' counterparties. In

    contrast, the Proposing Release said, non-dealers tend to enter into

    swaps with swap dealers more often than with other non-dealers. The

    Proposing Release noted that it is likely that swap dealers are

    involved in most or all significant parts of the swap markets.\25\

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    \25\ See id. at 80177.

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    The Proposing Release concluded that this functional approach would

    identify as swap dealers those persons whose function is to serve as

    the points of connection in the swap markets. Thus, requiring

    registration and compliance with the requirements of the Dodd-Frank Act

    by such persons would thereby reduce risk and enhance operational

    standards and fair dealing in those markets.\26\

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    \26\ See id.

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    The Proposing Release also noted that the swap markets are diverse

    and encompass a wide variety of situations in which parties enter into

    swaps with each other, and invited comment as to what aspects of the

    parties' activities in particular situations should, or should not, be

    considered swap dealing activities. Specifically, the Proposing Release

    invited comment regarding persons who enter into swaps: (i) As

    aggregators; (ii) as part of their participation in physical markets;

    or (iii) in connection with the generation and transmission of

    electricity.\27\

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    \27\ See id. at 80183-84.

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    First, regarding aggregators, the Proposing Release noted that some

    persons, including certain cooperatives, enter into swaps with other

    parties in order to aggregate the swap positions of the other parties

    into a size that would be more amenable to entering into swaps in the

    larger swap market. The Proposing Release explained that, for example,

    certain cooperatives enter into swaps with smaller businesses because

    the smaller business cannot establish a commodity position large enough

    to be traded on a swap or futures market, or large enough to be of

    interest to larger financial institutions. The Proposing Release said

    that while such persons engage in activities that are similar in many

    respects to those of a swap dealer, it may be that the swap dealing

    activities of these aggregators would not exceed the de minimis

    threshold, and therefore they would not be swap dealers. The CFTC

    requested comment as to how the de minimis threshold would apply to

    such persons, and in general on the application of the swap dealer

    definition to this activity. The Proposing Release also noted that the

    CFTC was engaged in a separate rulemaking pursuant to section

    723(c)(3)(B) of the Dodd-Frank Act regarding swaps in agricultural

    commodities, and requested comment on the application of the swap

    dealer definition to dealers, including potentially agricultural

    cooperatives, that limit their dealing activity primarily to swaps in

    agricultural commodities.\28\

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    \28\ After publication of the Proposing Release, the CFTC

    adopted a final rule on agricultural swaps under which swaps in

    agricultural commodities will be permitted to transact subject to

    the same rules as all other swaps. See Agricultural Swaps; Final

    Rule, 76 FR 49291 (Aug. 10, 2011).

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    Second, the Proposing Release noted that the markets in physical

    commodities such as oil, natural gas, chemicals and metals have

    developed highly customized transactions, some of which would be

    encompassed by the statutory definition of the term ``swap,'' and that

    some participants in these markets engage in swap dealing activities

    that are above the proposed de minimis threshold. The CFTC invited

    comment as to any different or additional factors that should be

    considered in applying the swap dealer definition to participants in

    these markets.

    Third, the Proposing Release noted a number of complexities that

    arise when applying the swap dealer definition in connection with the

    generation and transmission of electricity. In particular, the

    Proposing Release noted that additional complexity results because

    electricity is generated, transmitted and used on a continuous, real-

    time basis, and because the number and variety of participants in the

    electricity market is very large, and some electricity services are

    provided as a public good rather than for profit. The CFTC invited

    comment as to any different or additional factors that should be

    considered in applying the swap dealer definition to participants in

    the generation and transmission of electricity. Specifically, the CFTC

    invited comment on whether there are special considerations, including

    without limitation special considerations arising from section

    [[Page 30599]]

    201(f) of the Federal Power Act,\29\ related to not-for-profit power

    systems such as rural electric cooperatives and entities operating as

    political subdivisions of a state and on the applicability of the

    exemptive authority in section 722(f) of the Dodd-Frank Act to address

    those considerations.

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    \29\ 16 U.S.C. 824(f).

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    b. ``Security-Based Swap Dealer'' Activity

    The Proposing Release noted the parallels between the definition of

    ``security-based swap dealer'' and the definition of ``dealer'' under

    the Exchange Act,\30\ as well as the fact that security-based swaps may

    be used to hedge risks associated with owning certain types of

    securities or to gain economic exposure akin to ownership of certain

    types of securities. As a result, the Proposing Release took the view

    that the same factors that are relevant to determining whether a person

    is a ``dealer'' under the Exchange Act also are generally relevant to

    the analysis of whether a person is a security-based swap dealer. The

    Proposing Release also addressed the relevance of the ``dealer-trader''

    distinction for identifying dealing activity involving security-based

    swaps,\31\ while recognizing that certain concepts associated with the

    dealer-trader distinction--particularly concepts involving ``turnover

    of inventory'' and ``regular place of business''--appeared potentially

    less applicable to the security-based swap dealer definition. In

    addition, the Proposing Release noted that under the dealer-trader

    distinction, we would expect that entities that use security-based

    swaps to hedge business risks, absent other activities, likely would

    not be dealers.\32\

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    \30\ See Exchange Act sections 3(a)(5)(A), (B), 15 U.S.C.

    78c(a)(5)(A), (B), as amended by Section 761(a)(1) of the Dodd-Frank

    Act.

    \31\ The Proposing Release referred to the fact that the SEC

    previously has noted that the dealer-trader distinction:

    ``recognizes that dealers normally have a regular clientele, hold

    themselves out as buying or selling securities at a regular place of

    business, have a regular turnover of inventory (or participate in

    the sale or distribution of new issues, such as by acting as an

    underwriter), and generally provide liquidity services in

    transactions with investors (or, in the case of dealers who are

    market makers, for other professionals).'' Proposing Release, 75 FR

    at 80177 (citing Securities Exchange Act Release No. 47364 (Feb. 13,

    2003) (footnotes omitted)). The Proposing Release further noted that

    other non-exclusive factors that are relevant for distinguishing

    between dealers and non-dealers can include receipt of customer

    property and the furnishing of incidental advice in connection with

    transactions. See id.

    \32\ See Proposing Release, 75 FR at 80177-78.

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    c. Additional Principles Common to Both Definitions

    i. ``Hold Themselves Out'' and ``Commonly Known in the Trade'' Tests

    The Proposing Release identified the following non-exclusive list

    of factors as potentially indicating that a person meets the ``hold

    themselves out'' and ``commonly known in the trade'' tests of the

    statutory dealer definitions:

    Contacting potential counterparties to solicit interest in

    swaps or security-based swaps;

    Developing new types of swaps or security-based swaps

    (which may include financial products that contain swaps or security-

    based swaps) and informing potential counterparties of the availability

    of such swaps or security-based swaps and a willingness to enter into

    such swaps or security-based swaps with the potential counterparties;

    Membership in a swap association in a category reserved

    for dealers;

    Providing marketing materials (such as a Web site) that

    describe the types of swaps or security-based swaps that one is willing

    to enter into with other parties; or

    Generally expressing a willingness to offer or provide a

    range of financial products that would include swaps or security-based

    swaps.\33\

    ---------------------------------------------------------------------------

    \33\ See id. at 80178.

    ---------------------------------------------------------------------------

    The Proposing Release further stated that the test for being

    ``commonly known in the trade'' as a swap dealer or security-based swap

    dealer may appropriately reflect, among other factors, the perspective

    of persons with substantial experience with and knowledge of the swap

    and security-based swap markets (regardless of whether a particular

    entity is known as a dealer by persons without that experience or

    knowledge). The Proposing Release also stated that holding oneself out

    as a security-based swap dealer likely would encompass a person who is

    a dealer in another type of security entering into a security-based

    swap with a customer, as well as a person expressing its availability

    to enter into security-based swaps, regardless of the direction of the

    transaction or across a broad spectrum of risks.\34\

    ---------------------------------------------------------------------------

    \34\ See id.

    ---------------------------------------------------------------------------

    ii. Market Making

    In addressing the statutory definitions' ``making a market'' test,

    the Proposing Release noted that while continuous two-sided quotations

    and a willingness to buy and sell a security are important indicators

    of market making in the equities market, these indicia may not be

    appropriate in the swap and security-based swap markets. The proposal

    also noted that nothing in the statutory text or legislative history

    suggested the intent to impute a ``continuous'' activity requirement to

    the dealer definitions.\35\

    ---------------------------------------------------------------------------

    \35\ See id.

    ---------------------------------------------------------------------------

    iii. No Predominance Test

    The Proposing Release further addressed whether a person should be

    a dealer only if that activity is the person's sole or predominant

    business, and took the view that such an approach was not consistent

    with the statutory definition. The Proposing Release rejected this as

    an unworkable test of dealer status because many parties that commonly

    are acknowledged as dealers also engage in other businesses that

    outweigh their swap or security-based swap dealing business in terms of

    transaction volume or other measures.\36\

    ---------------------------------------------------------------------------

    \36\ See id. at 80178-79.

    ---------------------------------------------------------------------------

    iv. Application to New Types of Wwaps and New Activities

    The Proposing Release noted that the Commissions intended to apply

    the dealer definitions flexibly when the development of innovative

    business models is accompanied by new types of dealer activity,

    following a facts-and-circumstances approach.\37\

    ---------------------------------------------------------------------------

    \37\ See id. at 80179.

    ---------------------------------------------------------------------------

    2. Commenters' Views

    Numerous commenters addressed the proposed rules and

    interpretations in connection with the ``swap dealer'' and ``security-

    based swap dealer'' definitions. Several commenters addressed

    principles that are common to the two dealer definitions, while a

    number of commenters also addressed interpretations in the Proposing

    Release that were specific to the ``swap dealer'' definition.

    a. ``Hold Themselves Out'' and ``Commonly Known in the Trade'' Tests

    Some commenters expressed the view that the persons that hold

    themselves out as or are commonly known as dealers are easy to

    identify.\38\ In addressing the ``hold themselves out'' and ``commonly

    known'' criteria of the dealer definitions, commenters placed

    particular focus on whether only dealers engage in the activities cited

    by the

    [[Page 30600]]

    Proposing Release, or whether those activities are common both to

    dealers and to other users of swaps and security-based swaps.

    Commenters particularly stated that end users contact potential

    counterparties,\39\ develop new types of swaps or security-based

    swaps,\40\ and propose terms or language for swap or security-based

    swap agreements.\41\ One commenter further stated that identifying

    dealing activity based on whether a person develops new types of swaps

    or proposes swap terms would discourage innovation and the free

    negotiation of swaps.\42\ Some commenters stated that merely responding

    to a request for proposals or quotations should not, in itself,

    constitute dealing.\43\ Commenters also criticized the Proposing

    Release's suggestion that criteria for identifying dealing activity

    include membership in a dealer category of a trade association,\44\ as

    well as providing marketing materials and offering a range of financial

    products.\45\ Commenters also argued for more objective criteria for

    identifying persons ``commonly known'' as dealers.\46\

    ---------------------------------------------------------------------------

    \38\ See transcript of Joint CFTC-SEC Staff Roundtable

    Discussion on Proposed Dealer and Major Participant Definitions

    Under Dodd-Frank Act, June 16, 2011 (``Roundtable Transcript'') at

    22-23 (remarks of Ron Filler, New York Law School), 50-51 (remarks

    of Ron Oppenheimer, Working Group of Commercial Energy Firms), 215

    (remarks of Bella Sanevich, NISA Investment Advisors LLC).

    \39\ See letters from the Financial Services Roundtable

    (``FSR'') dated February 22, 2011 (``FSR I''), the International

    Swap Dealers Association (``ISDA'') dated February 22, 2011 (``ISDA

    I'') and the Midsize Bank Coalition of America (``Midsize Banks'').

    \40\ See letters from the Committee on Capital Markets

    Regulation (``CCMR'') dated February 22, 2011 (``CCMR I''), FSR I,

    ISDA I and Midsize Banks.

    \41\ See letters from the BG Americas & Global LNG (``BG LNG'')

    dated February 22, 2011 (``BG LNG I''), CCMR I, EDF Trading North

    America, LLC (``EDF Trading'') and The Gavilon Group, LLC

    (``Gavilon'') dated February 21, 2011 (``Gavilon II'').

    \42\ See letter from EDF Trading.

    \43\ See meeting with American Electric Power, Calpine

    Corporation (``Calpine''), Constellation, DC Energy LLC (``DC

    Energy''), Edison International (``Edison Int'l''), Exelon Corp.,

    GenOn, Southern Company, Edison Electric Institute (``EEI'') and

    Electric Power Supply Association (``ESPA'') (collectively

    ``Electric Companies'') on April 13, 2011.

    \44\ See letter from ISDA I and joint letter from National Corn

    Growers Association (``NCGA'') and Natural Gas Supply Association

    (``NGSA'') (``NCGA/NGSA'') dated February 22, 2011 (``NCGA/NGSA

    I'').

    \45\ See letter from ISDA I.

    \46\ See letters from ISDA I and Peabody Energy Corporation

    (``Peabody'').

    ---------------------------------------------------------------------------

    Conversely, one commenter said that three particular activities

    cited in the Proposing Release--membership in a swap association

    category reserved for dealers, providing marketing materials and

    expressing a willingness to offer a range of financial products--are

    indicative of holding oneself out as a dealer or being commonly known

    in the trade as a dealer, and should be codified in the final rule.\47\

    Another commenter suggested other factors, such as having a derivatives

    sales team, that should be treated as indicators of dealer

    activity.\48\ Commenters also expressed the view that this aspect of

    the dealer definition should focus on whether a person solicits

    expressions of interest in swaps from a range of market

    participants,\49\ and that end users of swaps can actively seek out and

    negotiate swaps without necessarily being swap dealers.\50\

    ---------------------------------------------------------------------------

    \47\ See letter from FSR I.

    \48\ See meeting with Vitol, Inc. (``Vitol'') on February 16,

    2011.

    \49\ See letter from Midsize Banks.

    \50\ See letter from EDF Trading.

    ---------------------------------------------------------------------------

    b. Market Making

    Several commenters generally requested that the Commissions provide

    more guidance as to which activities constitute making a market in

    swaps or security-based swaps.\51\ Commenters also described various

    activities as indicating, or not indicating, market making activity.

    For example, two commenters expressed the view that market making is

    characterized by entering into swaps on one side of the market and then

    establishing offsetting positions on the other side of the market.\52\

    Other commenters equated market making to providing liquidity by

    regularly quoting bid and offer prices for swaps, and standing ready to

    enter into swaps.\53\ One commenter stated that market making activity

    is indicated by a person consistently presenting itself as willing to

    take either side of a trade.\54\ Two commenters said that market makers

    receive tangible benefits (such as reduced trading fees) in return for

    the obligation to transact when liquidity is required.\55\

    ---------------------------------------------------------------------------

    \51\ See joint letter from American Benefits Council and the

    Committee on Investment of Employee Benefits Assets (``ABC/CIEBA'')

    and letters from FSR I.

    \52\ See letters from DC Energy and FSR I.

    \53\ See letters from Edison Int'l, NextEra Energy Resources,

    LLC (``NextEra'') dated February 22, 2011 (``NextEra I'') and Vitol,

    and joint letter from American Electric Power, Edison Int'l, Exelon

    Corp., and Southern Company (``Utility Group'').

    \54\ See letter from ISDA I.

    \55\ See joint letter from EEI and EPSA (``EEI/EPSA'') and

    letter from Vitol.

    ---------------------------------------------------------------------------

    In contrast, one commenter said the proposal correctly did not

    limit market making to consistently quoting a two-sided market, because

    to do so would insert a loophole into the definition.\56\ Some

    commenters expressed the view that mere active participation in a

    market or entering into swaps on both sides of a market does not

    necessarily constitute market making.\57\ Others said that occasionally

    quoting prices on both sides of the market is not market making when

    done to obtain information about the market or to mask one's view of

    the market.\58\ One commenter stated that futures commission merchants

    (``FCMs'') and broker-dealers that facilitate customers' entering into

    swaps are not necessarily market makers.\59\ Other commenters urged the

    Commissions to reject the view that market making requires continuous

    activity.\60\

    ---------------------------------------------------------------------------

    \56\ See letter from Americans for Financial Reform (``AFR'').

    \57\ See letters from ABC/CIEBA, Managed Funds Association

    (``MFA'') dated February 22, 2011 (``MFA I''), and Vitol.

    \58\ See letters from NextEra Iand Vitol.

    \59\ See letter from Newedge USA LLC (``Newedge''); see also

    Roundtable Transcript at 39 (remarks of Eric Chern, Chicago Trading

    Company).

    \60\ See letters from American Federation of State, County and

    Municipal Employees (``AFSCME''), and FSR I.

    ---------------------------------------------------------------------------

    A number of commenters addressed the issue of how the dealer

    definitions should treat swaps or security-based swaps entered into on

    a trading platform such as a designated contract market (``DCM''),

    national securities exchange, swap execution facility (``SEF''), or

    security-based SEF (collectively referred to herein as

    ``exchanges'').\61\ Several stated that entering into swaps or

    security-based swaps on exchanges should not be considered in

    determining if a person is a dealer.\62\ Some of these commenters

    emphasized the fact that parties would not know the identity of the

    counterparty to the swap executed on an exchange (i.e., such swaps are

    ``anonymous''),\63\ while other commenters said that such swaps do not

    constitute ``accommodating demand'' for swaps or ``facilitating

    interest'' in swaps.\64\ Another commenter said that future means of

    executing swaps on exchanges are likely to be diverse, and it is

    premature to draw conclusions

    [[Page 30601]]

    about how they should be treated in the dealer definitions.\65\

    ---------------------------------------------------------------------------

    \61\ While some of these commenters specially addressed this

    issue in the context of whether a person is a market maker in swaps,

    others more generally addressed the issue in terms of whether a

    person is a dealer. For clarity, all of those comments are being

    addressed in the market maker context.

    \62\ See letters from EEI/EPSA, International Energy Credit

    Association (``IECA-Credit'') dated February 22, 2011 (``IECA-Credit

    I''), and NextEra I, joint letter from Shell Trading (US) Company

    and Shell Energy North America (US), L.P. (``Shell Trading'') dated

    February 22, 2011 (``Shell Trading I''), and joint letter from

    Allston Trading, LLC, Atlantic Trading USA LLC, Bluefin Trading LLC,

    Chopper Trading LLC, DRW Holdings, LLC, Eagle Seven, LLC, Endeavor

    Trading, LLC, Geneva Trading USA, LLC, GETCO, Hard Eight Futures,

    LLC, HTG Capital Partners, IMC Financial Markets, Infinium Capital

    Management LLC, Kottke Associates, LLC, Liger Investments Limited,

    Marquette Partners, LP, Nico Holdings LLC, Optiver US, Quantlab

    Financial, LLC, RGM Advisors, LLC, Tibra Trading America LLC,

    Traditum Group LLC, WH Trading and XR Trading LLC (``Traders

    Coalition'').

    \63\ See letters from Shell Trading I and Traders Coalition.

    \64\ See letters from EEI/EPSA, IECA-Credit I, and NextEra I.

    For further discussion of this issue, see parts II.A.4 and II.A.5

    below.

    \65\ See letter from Metropolitan Life Insurance Company

    (``MetLife'').

    ---------------------------------------------------------------------------

    Two commenters asserted that firms that provide liquidity in

    cleared and exchange-executed swaps by actively participating in the

    market provide heterogeneity among liquidity providers and thereby

    disperse risk, and further stated that to regulate such persons as swap

    dealers subject to increased capital requirements would discourage

    their participation in the market and increase risk.\66\

    ---------------------------------------------------------------------------

    \66\ See letters from Newedge and Traders Coalition; Roundtable

    Transcript at 39 (remarks of Eric Chern, Chicago Trading Company).

    ---------------------------------------------------------------------------

    One commenter expressed the view that the statutory definition uses

    dealing and market making interchangeably, and suggested that the

    analysis of whether a person acts as a dealer should be subsumed within

    the analysis of whether it acts as a market maker.\67\

    ---------------------------------------------------------------------------

    \67\ See letter from ISDA I.

    ---------------------------------------------------------------------------

    c. Exception for Activities Not Part of a ``Regular Business''

    Several commenters addressed the exception from the dealer

    definitions for swap or security-based swap activities that are not

    part of a ``regular business.'' Some commenters supported the

    Commissions' proposed interpretation in the context of the ``swap

    dealer'' definition and stated that this interpretation should be

    codified in the text of the final rule.\68\

    ---------------------------------------------------------------------------

    \68\ See letters from FSR I, MFA I and Midsize Banks.

    ---------------------------------------------------------------------------

    Many commenters said that the activity of entering into swaps or

    security-based swaps should not be deemed to be a ``regular business,''

    and thus not indicative of dealing activity, when the person's use of

    swaps or security-based swaps are ancillary to, or in connection with,

    a separate non-swap business that is the person's primary business.\69\

    Some commenters making this point said that when the person's primary

    business relates to physical commodities, the person's use of swaps

    relating to those commodities does not constitute a ``regular

    business.'' \70\ Other commenters stated that where a person enters

    into swaps to serve its own business needs, as opposed to serving the

    business needs of the counterparty, the person's use of swaps does not

    constitute a ``regular business.'' \71\ Other commenters said that the

    use of swaps to hedge the commercial risks of a business does not

    constitute a ``regular business'' of entering into swaps.\72\ Some

    commenters also suggested that the ``regular business'' exclusion

    should be interpreted to mean ``regular swap dealing business'' or

    ``regular security-based swap dealing business'' to prevent the dealer

    definitions from capturing hedgers.\73\

    ---------------------------------------------------------------------------

    \69\ See Roundtable Transcript at 88 (remarks of Steve Walton,

    Bank of Oklahoma).

    \70\ See letters from Atmos Energy Corporation (``Atmos

    Energy''), Dominion Resources, Inc. (``Dominion Resources''), EDF

    Trading, Edison Int'l, EEI/EPSA, Gavilon II, Hess Corporation and

    its affiliates (``Hess''), Mississippi Public Utility Staff, NextEra

    I, National Milk Producers Federation (``NMPF''), Shell Trading I,

    Utility Group and Working Group of Commercial Energy Firms

    (``WGCEF'') on the swap dealer definition dated February 22, 2011

    (``WGCEF I''), and meeting with Bunge on February 23, 2011.

    \71\ See letters from BT Pension Scheme Management Limited

    (``BTPS''), EDF Trading, EEI/EPSA and Vitol.

    \72\ See letters from American Petroleum Institute (``API'')

    dated February 22, 2011 (``API I''), Calpine, Coalition of Physical

    Energy Companies (``COPE'') dated February 22, 2011 (``COPE I''),

    Dominion Resources, EDF Trading, Edison Int'l and Peabody; see also

    Roundtable Transcript at 45 (remarks of Ed Prosser, Gavilon) and

    letter from Church Alliance. In addition, three commenters said that

    the interpretation of the provisions relating to a ``regular

    business'' in the Proposing Release is correct, because it will

    exclude from the definition of swap dealer those persons using swaps

    to hedge commercial risk. See letters from Air Transport Association

    of America, Inc. (``ATAA''), IECA-Credit I and joint letter from

    Petroleum Marketers Association of America and New England Fuel

    Institute.

    \73\ See letters from Church Alliance and Peabody.

    ---------------------------------------------------------------------------

    On the other hand, two commenters said that the proposed

    interpretation was correct in the view that the test of whether a

    person has a ``regular business'' of entering into swaps does not

    necessarily depend on whether a person's swap activities are a

    predominant activity, because such an approach would allow a person to

    engage in a significant level of swap dealing activity without

    registering as a swap dealer simply because the person also has

    substantial activities in a non-swap business or businesses.\74\

    ---------------------------------------------------------------------------

    \74\ See letters from AFR and Better Markets, Inc. (``Better

    Markets'') dated February 22, 2011 (``Better Markets I'').

    ---------------------------------------------------------------------------

    Other commenters suggested that the types of swap activities that a

    person engages in are relevant to determining whether the person has a

    ``regular business'' of entering into swaps. One commenter stated that

    a person has a ``regular business'' of entering into swaps when the

    person has a primary business of accommodating demand or facilitating

    interest in swaps,\75\ while others similarly emphasized that a

    ``regular business'' of entering into swaps is characterized by

    financial intermediation activities.\76\ One commenter took the view

    that a person that enters into swaps primarily with financial

    intermediaries does not have a ``regular business'' of entering into

    swaps.\77\

    ---------------------------------------------------------------------------

    \75\ See letter from IECA-Credit I.

    \76\ See letter from NextEra I and Shell Trading I. Another

    commenter disagreed with this approach, however, saying that a

    person who enters into swaps as an intermediary between smaller

    customers and larger financial institutions is not entering into

    swaps for its ``own account'' and therefore is not a swap dealer,

    but rather would be an FCM or introducing broker. See letter from

    MFX Solutions, Inc. (``MFX'') dated February 22, 2011 (``MFX I'').

    \77\ See letter from Traders Coalition.

    ---------------------------------------------------------------------------

    Some commenters said that the final rule should clarify the point

    at which a person's episodic or occasional swap activities become a

    ``regular business'' of entering into swaps.\78\ Others stated that the

    fact that a person enters into swaps frequently or with a large number

    of counterparties does not necessarily mean that the person has a

    ``regular business'' of entering into swaps.\79\

    ---------------------------------------------------------------------------

    \78\ See letters from BG LNG I and WGCEF I.

    \79\ See letters from NCGA/NGSA I and Vitol. One of these

    commenters asked that the final rule clarify that simply because a

    person engages in swap activity exceeding the thresholds for the de

    minimis exception from the swap dealer definition does not

    necessarily mean that the person is engaged in a ``regular

    business'' of swap dealing. See letter from Vitol.

    ---------------------------------------------------------------------------

    Commenters proposed specific tests for determining if a person has

    a ``regular business'' of entering into swaps. One commenter said the

    determination should look to whether a person enters into swaps to

    accommodate demand from other parties and to profit from a bid/ask

    spread on swaps (as opposed to swaps that are substitutes for physical

    transactions or positions and used by at least one party to hedge

    commercial risk), and consider specifically the volume, revenues and

    profits of such activities, the person's value at risk (VaR) and

    exposure from such activities, and its resources devoted to such

    activities.\80\ Another commenter said that the determination should be

    based on the nature of the person's business, the person's business

    purpose for using swaps, and the person's method of executing swap

    transactions (e.g., a person whose business primarily relates to

    physical commodities, who uses swaps to hedge commercial risk, and who

    executes swaps on an exchange would be less likely to have a ``regular

    business'' of entering into swaps).\81\

    ---------------------------------------------------------------------------

    \80\ See letter from NextEra I; see also letter from Hess

    (proposing similar criteria).

    \81\ See letter from Shell Trading I.

    ---------------------------------------------------------------------------

    One commenter argued that the ``regular business'' exception should

    apply to all four of the dealer tests--not only the test for persons

    that regularly enters into swaps or security-based swaps as an

    ``ordinary course of business''--and further argued that the ``regular

    business'' exception should be linked to a ``two-way market'' base

    [[Page 30602]]

    requirement to avoid commercial hedgers being encompassed by the dealer

    definitions.\82\

    ---------------------------------------------------------------------------

    \82\ See letter from ISDA dated I.

    ---------------------------------------------------------------------------

    d. Other Dealer Issues

    Commenters also addressed other issues in the Proposing Release,

    including: (i) Whether Congress intended that there be implicit

    preconditions to dealer status; (ii) whether the concepts of

    ``accommodating demand'' for swaps or security-based swaps or

    ``facilitating interest'' in swaps are useful in identifying dealers;

    and (iii) whether the interpretation of the dealer definitions should

    depend on pre-defined, objective criteria.

    i. Preconditions

    Several commenters said that the proposal is overbroad and would

    encompass persons that Congress did not intend to regulate as

    dealers.\83\ Comments in this vein said that the statutory definition

    should be interpreted to require that persons meet certain criteria or

    engage in certain activity, not explicitly stated in the statute, to be

    covered by the swap dealer definition. For instance, some commenters

    said that a dealer is a person who enters into swaps or security-based

    swaps on either side of the market and who profits from fees for doing

    so, or from the spread between the terms of swaps on either side of the

    market.\84\ Other commenters made a similar point, saying that swap

    dealers are those persons that intermediate between swap users on

    either side of the market.\85\

    ---------------------------------------------------------------------------

    \83\ See, e.g., letters from BG LNG I, EDF Trading, ISDA I,

    NCGA/NGSA dated February 17, 2012 (``NCGA/NGSA II'') and WGCEF I,

    and joint letter from American Farm Bureau Federation, American

    Soybean Association, National Association of Wheat Growers, National

    Cattlemen's Beef Association, National Corn Growers Association,

    National Council of Farmer Cooperatives, National Grain and Feed

    Association, National Milk Producers Federation and National Pork

    Producers Council (``Farmers' Associations'').

    \84\ See letters from COPE I, Edison Int'l, Hess, ISDA I, Shell

    Trading I, Utility Group, Vitol and WGCEF I; see also Roundtable

    Transcript at 43-45 (remarks of Ed Prosser, Gavilon). However, other

    commenters questioned whether profiting from a bid/ask spread is a

    relevant test of dealer status, and emphasized that dealers are

    those persons who take risk by entering into swaps or security-based

    swaps on both sides of the market. See Roundtable Transcript at 21,

    56 (remarks of Richard Ostrander, Morgan Stanley) and 43 (remarks of

    Russ Wasson, National Rural Electric Cooperative Association

    (``NRECA'')). Another commenter pointed out that it could be

    difficult to determine how a person is profiting from entering into

    swaps. See Roundtable Transcript at 42 (remarks of Michael Masters,

    Better Markets).

    \85\ See letters from API I, BG LNG I and NCGA/NGSA II.

    ---------------------------------------------------------------------------

    The commenters were not all in agreement on this, however. Several

    commenters (including some of those that said swap dealers enter into

    swaps on both sides of the market) also stated that there are a variety

    of situations in which a person's activity of contemporaneously

    entering into swaps on both sides of the market is not indicative of

    dealing activity.\86\ One commenter said that it would not be

    appropriate to require that a person enter into swaps or security-based

    swaps on both sides of the market as a litmus test for dealer status,

    because to do so would create loopholes in the definition.\87\ Two

    commenters also supported rejection of any interpretation that would

    limit the dealer definitions to encompass only those entities that

    solely or predominately act as dealers.\88\

    ---------------------------------------------------------------------------

    \86\ The examples cited were: entering into swaps on either side

    of a market depending on a firm's commercial purpose for entering

    each particular swap (see letters from the Industrial Energy

    Consumers of America (``IECA-Consumers'') and WGCEF I, and letter

    from the Not-For-Profit Electric End User Coalition (``NFPEEU''),

    consisting of NRECA, American Public Power Association (``APPA'')

    and Large Public Power Council (``LPPC''); see also Roundtable

    Transcript at 44 (remarks of Ed Prosser, Gavilon)); entering into

    swaps on both sides of an illiquid market for purposes of price

    discovery or to elicit bids and offers from other market

    participants (see letters from Hess, Vitol and WGCEF I); and

    entering into swaps on both sides of the market as part of an

    investment strategy (see letter from ABC/CIEBA).

    \87\ See letter from AFR.

    \88\ See letters from AFR and Better Markets I.

    ---------------------------------------------------------------------------

    In addition, commenters were particularly divided as to whether

    acting as an intermediary always is indicative of swap dealing, as some

    commenters said that a person is not a swap dealer when it simply

    stands between two parties by entering into offsetting swaps with each

    party.\89\

    ---------------------------------------------------------------------------

    \89\ See letters from BOKF, National Association (``BOK'') dated

    January 13, 2012 (``BOK V''), MFX I, Newedge and Northland Energy

    Trading LLC (``Northland Energy''); see also Roundtable Transcript

    at 48 (remarks of John Nicholas, Newedge). One commenter queried

    whether the final rule should clarify whether a customer

    relationship between the parties to a swap is necessary in order for

    the swap to be relevant in determining whether either of the parties

    is a swap dealer. See letter from Representative Scott Desjarlais

    (``Rep. Desjarlais'').

    ---------------------------------------------------------------------------

    ii. ``Accommodating Demand'' and ``Facilitating Interest''

    A number of commenters addressed the Proposing Release's view that

    a tendency to accommodate demand for swaps and a general availability

    to enter into swaps to facilitate other parties' interest in swaps

    (referred to here as ``accommodating demand'' and ``facilitating

    interest'') are characteristic of swap dealers. Some commenters stated

    that accommodating demand and facilitating interest would not be

    effective factors to identify swap dealers, particularly in bilateral

    negotiations where it is difficult to say which party is accommodating

    demand for swaps.\90\ Other commenters said the activities of

    accommodating demand or facilitating interest are indicative of swap

    dealing only in certain circumstances, such as when they are not

    related to a person's commodity business,\91\ or when done with the

    purpose of serving the needs of the other party to the swap.\92\ Some

    commenters argued that the statement in the Proposing Release that swap

    dealers are likely involved in most or all significant parts of the

    swap markets is incorrect in the market for energy swaps. There, the

    commenters said, persons can find counterparties for swaps without the

    intermediation of a swap dealer, and swaps entered into directly by two

    end users are more frequent.\93\

    ---------------------------------------------------------------------------

    \90\ See letters from NextEra I and Peabody and meeting with

    Vitol on February 15, 2011.

    \91\ See letter from Shell Trading I.

    \92\ See letters from IECA-Credit I, National Association of

    Insurance Commissioners (``NAIC''), Vitol and WGCEF I. One of these

    commenters also said that entering into a bespoke swap with a

    registered swap dealer, in which the swap dealer lays off risk,

    should not be viewed as accommodating demand or facilitating

    interest. See letter from Vitol.

    \93\ See letter from BG LNG I, NCGA/NGSA I, NFPEEU, NRG Energy,

    Inc. (``NRG Energy'') and WGCEF I and meeting with Vitol on February

    16, 2011.

    ---------------------------------------------------------------------------

    Other commenters, though, said that the proposal's focus on

    accommodating demand and facilitating interest strikes the right

    balance and that the proposed approach is generally correct.\94\

    Another commenter did not object to including accommodating demand and

    facilitating risk as factors in the definition, but said that those

    factors should be applied flexibly.\95\

    ---------------------------------------------------------------------------

    \94\ See letters from AFR and MFX I.

    \95\ See letter from National Grain and Feed Association

    (``NGFA'') dated February 22, 2011 (``NGFA I'').

    ---------------------------------------------------------------------------

    iii. Application of Objective Criteria, and Additional Factors

    Some commenters, specifically addressing the CFTC's proposed

    interpretive approach to the ``swap dealer'' definition, said that the

    final rule should set out objective criteria that market participants

    could use to determine whether or not they are covered by the

    definition and therefore required to register as swap dealers.\96\

    [[Page 30603]]

    Others focused especially on statements in the Proposing Release to the

    effect that swap dealers are those persons who ``tend to'' engage in

    certain activities, and that persons who engage in certain activities

    are ``likely'' to be swap dealers, as being overly subjective and

    difficult to interpret.\97\

    ---------------------------------------------------------------------------

    \96\ See letters from BG LNG I, EEI/EPSA, Peabody, Rep.

    Desjarlais and Utility Group. Some commenters said that the CFTC's

    interpretive approach to the swap dealer definition should be

    codified in the text of the final rule. See letters from Alternative

    Investment Management Association Limited (``AIMA'') dated February

    22, 2011 (``AIMA I'') and COPE I.

    \97\ See letters from BG LNG I, Chesapeake Energy Corporation

    (``Chesapeake Energy''), COPE I, ISDA I, Vitol and WGCEF I. Some

    commenters focused on particular aspects of the swap dealer

    definition as requiring further detail, such as, for example, what

    it means to be ``commonly known in the trade'' as a swap dealer (see

    letter from Peabody) and the definition of market making (see

    letters from Midsize Banks and Peabody).

    ---------------------------------------------------------------------------

    Certain commenters suggested specific objective criteria to use to

    identify swap dealers. One commenter said that swap dealing activity is

    characterized by more frequent use of swaps; having substantial staff

    and technological resources devoted to swaps; a larger portion of

    revenue and profit being derived from swap activity; and owning fewer

    physical assets related to the type of swaps entered into.\98\ Another

    commenter said that to identify swap dealers, the CFTC should compare a

    person's revenue or profits generated by swap activity to its overall

    revenue or profits; compare a person's total business volume to the

    volume, VaR and exposure associated with the swap activity; compare a

    person's total business resources to the resources devoted to swap

    activity; and consider ownership or control of physical assets in the

    specific market or region to which the person's swap activity is

    tied.\99\

    ---------------------------------------------------------------------------

    \98\ See letter from Hess.

    \99\ See letter from NextEra I.

    ---------------------------------------------------------------------------

    More generally, some commenters supported codification of more

    concrete tests in connection with the dealer definitions.\100\ However,

    other commenters said that the use of bright line rules to determine

    whether a person is a dealer would be inappropriate given the dynamic

    nature of the swap and security-based swap markets. These commenters

    supported a facts and circumstances approach to the dealer definition

    as a better approach.\101\ One commenter also raised issues about the

    sources of information that may be considered as part of a dealer

    determination.\102\

    ---------------------------------------------------------------------------

    \100\ See, e.g., letters from EEI/EPSA, FSR I, ISDA I, NextEra I

    and WGCEF I.

    \101\ See letters from Better Markets I, Chris Barnard

    (``Barnard'') and Prof. Michael Greenberger, University of Maryland

    School of Law (``Greenberger'').

    \102\ See letter from ISDA I (stating that sources of

    information considered by the Commissions in determining dealer

    status should be revealed to the entity being evaluated).

    ---------------------------------------------------------------------------

    e. Application of Exchange Act ``Dealer-Trader'' distinction

    i. Security-Based Swap Dealer Definition

    A number of commenters supported the proposed use of the dealer-

    trader distinction under the Exchange Act to interpret the ``security-

    based swap dealer'' definition.\103\ Two commenters, however,

    specifically opposed use of the distinction in the context of security-

    based swaps, arguing that use of the distinction would create confusion

    or would be inconsistent with the goal of improved transparency.\104\

    ---------------------------------------------------------------------------

    \103\ See, e.g., letters from Coalition for Derivatives End-

    Users (``CDEU''), CCMR I, ISDA I and MetLife.

    \104\ See letters from AFR and AFSCME.

    ---------------------------------------------------------------------------

    ii. Swap Dealer Definition

    Some commenters said that the CFTC should apply the dealer-trader

    distinction as it has been interpreted with respect to the definition

    of ``dealer'' under the Exchange Act to identify swap dealers.\105\

    Some commenters said that the applicable interpretations under the

    Exchange Act mean that swaps a person uses for proprietary trading

    (including for speculative purposes) should not be considered in

    determining if the person is a swap dealer because dealers enter into

    transactions in order to profit from spreads or fees regardless of

    their view of the market for the underlying item, whereas traders enter

    into transactions in order to take a view on the direction of the

    market or to obtain exposure to movements in the price of the

    underlying item.\106\ Two commenters said that if the CFTC applied the

    distinction, traders should be subject to potential registration as

    major swap participants, and dealers should be subject to regulation as

    swap dealers.\107\ Commenters acknowledged differences between the

    market for swaps and the market for securities, but said that the

    Exchange Act interpretations are still relevant.\108\

    ---------------------------------------------------------------------------

    \105\ Some of these commenters said that, since some provisions

    in the statutory swap dealer definition are similar to the

    definition of a ``dealer'' under the Exchange Act, Congress intended

    that the two definitions would be applied in the same way. See

    letters from API I, BG LNG I, CDEU, IECA-Consumers and WGCEF I.

    Others said that the CFTC should apply these interpretations because

    they have been effectively applied for a long time in the context of

    securities. See letters from CCMR I and MFA I.

    \106\ See letters from Gavilon II, and Next Era I, and meetings

    with Electric Companies on April 13, 2011 and WGCEF on April 28,

    2011. Another commenter said the interpretations mean that dealers

    and traders can be distinguished by their activities: dealers hold

    themselves out as buying and selling on a regular basis, derive

    income from providing services in the chain of distribution, and

    profit from price spreads, while traders do not provide services or

    extend credit but, rather, profit from changes in the market value

    of underlying items. See letter from API I.

    \107\ See letters from EDF Trading and IECA-Consumers.

    \108\ See letters from API I, Gavilon I and IECA-Consumers.

    ---------------------------------------------------------------------------

    On the other hand, some commenters agreed with the CFTC's view not

    to apply Exchange Act interpretations to the definition of the term

    ``swap dealer.'' These commenters said that it is appropriate not to

    apply the interpretations under the Exchange Act to identify persons

    that meet the swap dealer definition under the CEA.\109\

    ---------------------------------------------------------------------------

    \109\ See letters from AFR and AFSCME; see also joint meeting

    with AFR and Better Markets on March 17, 2011 (dealer-trader

    distinction not helpful in identifying swap dealers because the

    transparency and operational robustness of the swap market is much

    lower than in the securities market). One commenter said the

    precedents should be applied only by the SEC to identify security-

    based swap dealers. See letter from NAIC.

    ---------------------------------------------------------------------------

    e. Application to Particular Swap Markets

    i. Aggregators

    Certain commenters addressed persons who enter into swaps as

    aggregators, with most of those commenters discussing agricultural

    cooperatives. Commenters said that agricultural cooperatives that hedge

    their own risks or the risks of their members regarding agricultural

    commodities should be excluded from the swap dealer definition because

    Congress did not intend to treat agricultural cooperatives as swap

    dealers and because agricultural cooperatives are in effect an

    extension of their members.\110\ Some commenters said that the

    agricultural cooperatives' use of swaps allows their members to hedge

    risks when the members' transactions are too small for (or otherwise

    not qualified for) the futures markets.\111\

    ---------------------------------------------------------------------------

    \110\ See letters from Dairy Farmers of America (``DFA''),

    Growmark, Land O'Lakes, Inc. (``Land O'Lakes'') dated February 22,

    2011 (``Land O'Lakes II''), National Council of Farmer Cooperatives

    (``NCFC'') dated February 22, 2011 (``NCFC I'') and NMPF. One

    commenter also said that a subsidiary of an agricultural cooperative

    that enters into swaps with its parent cooperative, and the members

    of the parent cooperative, should be excluded from the swap dealer

    definition for the same reason. See meeting with Agrivisor. Another

    commenter said that an agricultural cooperative's swaps with farmers

    and other persons for risk management should be disregarded in

    determining if the cooperative is a swap dealer so long as the swaps

    relate to the marketing function of the cooperative, even if the

    swaps are not with members of the cooperative. See letter from NMPF.

    \111\ See letters from DFA and Growmark.

    ---------------------------------------------------------------------------

    Some commenters said that an exclusion from the swap dealer

    definition also should be available to private companies that serve as

    aggregators for swaps in agricultural commodities or otherwise offer

    swaps

    [[Page 30604]]

    for agricultural risk management.\112\ These commenters said that such

    an exclusion would reduce the costs and regulatory burdens imposed on

    such companies and therefore provide a broader choice of swap providers

    to farmers and other agricultural market participants, which they said

    would reduce risks.\113\

    ---------------------------------------------------------------------------

    \112\ See letters from Farmers' Associations, NGFA I and NMPF.

    \113\ See id.

    ---------------------------------------------------------------------------

    One commenter discussed a small energy firm that aggregates demand

    for swaps from small energy retailers and consumers. This commenter

    said that such aggregators should be excluded from the swap dealer

    definition because imposing the swap dealer regulations (which would be

    promulgated with large financial firms in mind) on such firms would

    increase costs for the aggregators, discourage the aggregators'

    offering of swaps, and thereby reduce choice and efficiency in the

    market.\114\ Another commenter said that a firm that enters into swaps

    with microfinance lenders and offsetting swaps with commercial banks is

    akin to an introducing broker or FCM, and should be excluded from the

    swap dealer definition on the grounds that it does not enter into swaps

    on its own initiative, but rather to provide access to the swap markets

    to smaller counterparties.\115\

    ---------------------------------------------------------------------------

    \114\ See letter from Northland Energy. This commenter defined

    an ``aggregator'' as a person who: (i) Enters into swaps

    predominantly in one direction with counterparties that are using

    swaps to establish bona fide hedges; and (ii) offsets risks

    associated with such swaps using regulated futures contracts or

    cleared swaps.

    \115\ See letter from MFX dated June 3, 2011 (``MFX II''). This

    commenter said that the exclusion should be available to a person

    who operates primarily on a not-for-profit basis and limits its swap

    activities to offering swaps to persons in underserved markets and

    offsetting such swaps, and who meets other requirements to limit the

    scope of the exclusion.

    ---------------------------------------------------------------------------

    Another commenter said that there is no need for any special

    treatment of aggregators in the swap dealer definition. According to

    this commenter, the CFTC's guidance regarding the definition and the de

    minimis exception from the definition address the relevant issues

    properly and completely.\116\

    ---------------------------------------------------------------------------

    \116\ See letter from Better Markets I.

    ---------------------------------------------------------------------------

    ii. Physical Commodity Swaps

    Commenters that discussed physical commodity swaps primarily

    focused on swaps related to energy commodities such as oil, natural gas

    and electricity. The commenters said that the market for these swaps is

    different from the market for swaps on interest rates and other

    financial commodities because, among other things, the swaps are used

    to mitigate price and delivery risks directly linked to a commercial

    enterprise; less swap activity flows through intermediaries; the

    markets for the underlying physical commodities are separately

    regulated; and the failure of a commodity market participant is not

    likely to impact financial markets as a whole.\117\ Therefore, these

    commenters believe, the application of the swap dealer definition to

    participants in these physical commodity swap markets should be

    different from the application to participants in the financial

    commodity swap markets.\118\ Some commenters said that imposing the

    costs of swap dealer regulation on participants in the markets for

    physical commodity swaps would discourage participation in the market,

    thereby reducing liquidity and increasing market concentration.\119\

    ---------------------------------------------------------------------------

    \117\ See letters from BG LNG I, Dominion Resources, National

    Energy Marketers Association (``NEM''), NFPEEU, Vitol and WGCEF I

    joint letter from Senator Debbie Stabenow and Representative Frank

    Lucas (many commercial end-users of swaps with inherent physical

    commodity price risk use swaps to hedge such risk and otherwise for

    their own trading objectives and not for the benefit of others) and

    meetings with Bunge on May 18, 2011 and Electric Companies on April

    13, 2011.

    \118\ See id.

    \119\ See letters from Dominion Resources, NEM and NFPEEU.

    ---------------------------------------------------------------------------

    iii. Electricity Swaps

    Commenters on the use of swaps in connection with the generation

    and transmission of electricity addressed a variety of issues. First,

    commenters said that markets related to electricity are different from

    markets for other physical commodities in that electricity must be

    generated and transmitted at the time it is needed (it cannot be stored

    for future use); the overall demand for electricity is inelastic but

    demand at any particular time is subject to external variables, such as

    weather; the generation, transmission and use of electricity is widely

    dispersed and geographically specific; the markets are overseen by

    regulators such as state Public Utility Commissions, regional

    transmission organizations (``RTOs'') and the Federal Energy Regulatory

    Commission (``FERC''); and government mandates require continuous

    supply of electricity and treat electricity as a ``public good.'' \120\

    Commenters said that because of these differences, the use of swaps

    related to electricity is different from the use of swaps on other

    physical commodities in that electricity swaps: Are more highly

    customized to a particular place and time; are more likely to relate to

    a short time period or be more frequently entered into; typically can

    be tied to a specific generation, transmission or use of electricity;

    are more likely to be entered into directly by end-users rather than

    through dealers; are likely to be entered into by electricity companies

    on both sides of the market; and in many cases were subject to

    regulatory oversight prior to the Dodd-Frank Act.\121\

    ---------------------------------------------------------------------------

    \120\ See letters from Edison Int'l, the staff of the FERC

    (``FERC Staff''), National Association of Regulatory Utility

    Commissioners (``NARUC''), NEM, NextEra I, NFPEEU and National Rural

    Utilities Cooperative Finance Corporation (``NRU CFC'') dated

    February 14, 2011 (``NRU CFC I''), joint letter from NRECA, APPA,

    LPPC, EEI and EPSA (``Electric Trade Associations'') and meetings

    with Electric Companies on April 13, 2011 and NFPEEU on January 29,

    2011.

    \121\ See letters from Edison Int'l, EEI/EPSA, Electric Trade

    Associations, FERC Staff, NextEra I and NFPEEU and meeting with

    Electric Companies on April 13, 2011.

    ---------------------------------------------------------------------------

    Commenters made various points regarding how swaps related to

    electricity should be treated for purposes of the swap dealer

    definition. A coalition of not-for-profit power utilities and electric

    cooperatives said that electricity cooperatives should be excluded from

    the swap dealer definition because they are non-profit entities that

    enter into swaps for the benefit of their members, they do not hold

    themselves out as swap dealers, they do not make markets, and their

    swaps are not necessarily reflective of market rates.\122\ Other

    commenters said that swaps related to transactions on tariff schedules

    approved by FERC or the Electric Reliability Council of Texas should be

    disregarded in determining if a person is a swap dealer.\123\ And, some

    commenters said that any special treatment of swaps related to

    electricity should apply not only to companies that generate, transmit

    or distribute electricity, but also to energy marketing companies that

    use swaps to benefit from price changes in the underlying energy

    commodities or to hedge related risks.\124\

    ---------------------------------------------------------------------------

    \122\ See letter from NFPEEU. This commenter said the exclusion

    from the swap dealer definition should extend to persons acting as

    an operating or purchasing agent for other utilities in connection

    with energy infrastructure products, or otherwise entering into

    energy commodity swaps on behalf of other end users.

    \123\ See letters from EDF Trading, FERC Staff and NARUC.

    \124\ See letters from DC Energy, EDF Trading and EEI/EPSA.

    ---------------------------------------------------------------------------

    On the other hand, some commenters acknowledged that a person who

    makes a market in swaps related to electricity by standing ready to

    enter into such swaps in order to profit from a bid/ask spread would be

    a swap dealer, even if the person was in the business of generating,

    transmitting or distributing

    [[Page 30605]]

    electricity and owned physical facilities for that purpose.\125\

    ---------------------------------------------------------------------------

    \125\ See letter from EEI/EPSA and meeting with Electric

    Companies on April 13, 2011.

    ---------------------------------------------------------------------------

    f. Suggested Exlusions From the Dealer Definitions

    Several commenters took the view that the swap dealer and security-

    based swap dealer definitions should categorically exclude, or should

    be interpreted in a way that would be expected to exclude, a variety of

    types of persons or transactions. Commenters particularly suggested

    that the following categories of persons should be excluded from the

    dealer definitions: Agricultural cooperatives and electric cooperatives

    (as addressed above), employee benefit plans as defined in the Employee

    Retirement Income Security Act of 1974 (``ERISA''),\126\ farm credit

    system institutions,\127\ Federal Home Loan Banks,\128\ insured

    depository institutions that limit their swap dealing activity to

    riskless principal transactions,\129\ FCMs and broker-dealers that

    limit their swap dealing activity to riskless principal

    transactions,\130\ financial guaranty insurers and their affiliates

    that do not enter into new swaps,\131\ asset managers,\132\ non-

    financial companies offering swaps related to their physical commodity

    business,\133\ any person who enters into swaps or security-based swaps

    only with registered dealers and major participants,\134\ persons that

    do not pose systemic risk,\135\ hedge funds \136\ and entities that

    enter into swaps or security-based swaps solely in a fiduciary

    capacity.\137\

    ---------------------------------------------------------------------------

    \126\ See letter from ABC/CIEBA.

    \127\ See letter from Farm Credit Council dated February 22,

    2011 (``Farm Credit Council I'').

    \128\ See letters from Credit Union National Association

    (``CUNA'') and Federal Home Loan Banks (``FHLB'') dated February 22,

    2011 (``FHLB I'').

    \129\ See letter from BOK dated January 31, 2011 (``BOK I'');

    but see letter from Vitol at 7 (riskless principal transactions are

    a ``good model for true swap dealing activity'').

    \130\ See letter from Newedge.

    \131\ See letter from Association of Financial Guaranty Insurers

    (``AFGI'').

    \132\ See letter from BlackRock, Inc. (``BlackRock'') dated

    February 22, 2011 (``BlackRock I'').

    \133\ Commenters making this point varied in their phrasing of

    potential exclusions, and particularly suggested exclusions for:

    Agricultural firms offering swaps as risk management tools related

    to physical commodities (see letter from NGFA I); all firms, other

    than financial entities whose primary business is swap dealing (see

    letter from NEM); any person that uses swaps only to reduce price

    volatility, enters into a volume of swaps relating to any physical

    commodity that is less than the volume of its trading in that

    commodity, and is not making a market (see letter from Chesapeake

    Energy); or any person that limit its use of swaps to hedging or

    speculating (see letters from API I).

    \134\ See letter from ISDA I.

    \135\ See letters from NARUC and NCGA/NGSA I.

    \136\ See letter from MFA I.

    \137\ See letters from FSR dated February 22, 2011 and Midsize

    Banks.

    ---------------------------------------------------------------------------

    Commenters also suggested that the dealer definitions categorically

    exclude, or should be interpreted to exclude, the following types of

    swaps and security-based swaps: Exchange-cleared swaps and security-

    based swaps,\138\ options to make or receive delivery of physical

    commodities,\139\ cash forward transactions with embedded swaps and

    book-out transactions,\140\ swaps or security-based swaps that are used

    for hedging or mitigating commercial risk,\141\ swaps entered into to

    profit from future changes in the price of the underlying

    commodity,\142\ swaps or security-based swaps entered into as a

    fiduciary or agent for another person,\143\ swaps or security-based

    swaps entered into for purposes of price discovery,\144\ and, as noted

    above, swaps related to items that are covered by a tariff approved by

    FERC or the Electric Reliability Council of Texas.\145\

    ---------------------------------------------------------------------------

    \138\ See letters from Commodity Markets Council (``CMC''), EEI/

    EPSA, IECA-Credit I, NextEra I, Shell Trading I, Utility Group and

    Vitol.

    \139\ See letters from NextEra I and WGCEF I. The commenters

    acknowledged that such options may or may not be included in the

    definition of ``swap.''

    \140\ See letter from CMC.

    \141\ See, e.g., letters from Edison Int'l and WGCEF I and joint

    letter from Senator Stabenow and Representative Lucas (also saying

    that definition of ``hedging'' should be consistent with respect to

    the dealer and major participant definitions and the end-user

    exception from clearing).

    \142\ See letters from EEI/EPSA, NextEra I, Utility Group and

    WGCEF I.

    \143\ See letters from Midsize Banks, NFPEEU and FSR I.

    \144\ See letters from EEI/EPSA, Vitol and WGCEF I.

    \145\ See letters from EDF Trading, FERC Staff and NARUC.

    ---------------------------------------------------------------------------

    In contrast, some commenters opposed providing any categorical

    exclusions from the dealer definitions. One commenter stated that the

    definitions' focus on a person's activities--as opposed to whether that

    person falls within a particular category--is a better means of

    determining whether the person is a swap dealer.\146\ Another commenter

    described the requested exclusions as attempts to achieve carve-outs

    that are not provided for in the statute.\147\

    ---------------------------------------------------------------------------

    \146\ See letter from Better Markets I.

    \147\ See letter from AFSCME. Additional commenters emphasized

    the need for transparency about swaps and swap activities. See

    letters from Jason Cropping and BJ D'Milli.

    ---------------------------------------------------------------------------

    Lastly, several commenters addressed the extraterritorial

    application of the definitions of the terms ``swap dealer,''

    ``security-based swap dealer,'' ``major swap participant,'' ``major

    security-based swap participant,'' and ``eligible contract

    participant.'' In general, the commenters addressed when and how the

    definitions should be applied to persons based outside the U.S. and how

    the definitions should take account of non-U.S. requirements that may

    be applicable to such persons.\148\ The Commissions intend to

    separately address issues related to the application of these

    definitions to non-U.S. persons in the context of the application of

    Title VII to non-U.S. persons.

    ---------------------------------------------------------------------------

    \148\ See, e.g., letters from FSR I, Institute of International

    Bankers, ISDA I, Investment Management Association, Japan Financial

    Services Agency, Securities Industry and Financial Markets

    Association (``SIFMA'') dated February 3, 2011 (``SIFMA I''), and

    the World Bank Group, joint letter from the Autorit[eacute] de

    contr[ocirc]le prudential and the Autorit[eacute] des marches

    financiers, joint letter from Bank of America Merrill Lynch,

    Barclays Capital, BNP Paribas S.A. (``BNP Paribas''), Citi,

    Cr[eacute]dit Agricole Corporate and Investment Bank, Credit Suisse

    Securities (USA), Deutsche Bank AG (``Deutsche Bank''), HSBC, Morgan

    Stanley, Nomura Securities International, Inc. (``Nomura

    Securities''), Soci[eacute]t[eacute] G[eacute]n[eacute]rale and UBS

    Securities LLC (``Twelve Firms''), joint letter from the Bank of

    Tokyo-Mitsubishi UFJ, Ltd., Mizuho Corporate Bank, Ltd. and Sumitomo

    Mitsui Banking Corporation, and joint letter from Barclays Bank PLC,

    BNP Paribas, Credit Suisse AG, Deutsche Bank, HSBC, Nomura

    Securities, Rabobank Nederland, Royal Bank of Canada, the Royal Bank

    of Scotland Group pLc, Soci[eacute]t[eacute] G[eacute]n[eacute]rale,

    the Toronto-Dominion Bank and UBS AG.

    ---------------------------------------------------------------------------

    g. Cost-Benefit Issues and Hedging Deterrence

    Several commenters emphasized the cost of being regulated as a

    dealer, and emphasized that an overbroad scope of the dealer

    definitions would impose significant unwarranted costs on entities

    contrary to the goals of the Dodd-Frank Act, and would deter the use of

    swaps and security-based swaps for hedging.\149\ Some commenters also

    noted that impact of the provisions of section 716 of the Dodd-Frank

    Act on entities that are deemed to be swap

    [[Page 30606]]

    dealers or security-based swap dealers.\150\ Also, one commenter

    suggested that using a qualitative test for the dealer definition might

    increase costs due to regulatory uncertainty.\151\

    ---------------------------------------------------------------------------

    \149\ See joint letter from Representatives Spencer Bachus and

    Frank Lucas at 2 (``Casting an overly-broad net in defining [dealer

    and major participant] could force some smaller participants to

    leave the marketplace as a result of increased costs, or eliminate

    certain types of contracts used for hedging. If either occurs,

    businesses will be left exposed to market volatility and the

    consequences will ultimately be felt by Americans in the form of

    increased consumer costs.'') and letters from ISDA Iat 7 (``The

    substantial additional burdens and costs of Dealer regulation must

    be reserved for those whose business it is to `make the market,'

    that is, those who consistently both buy and sell. This is in accord

    with Dodd-Frank Act's market regulatory goals, as well as the

    legislation's obvious intent to preserve healthy growth and

    innovation in the U.S. swap markets.'' (footnote omitted)), Peabody

    at 2-3 (``Legal uncertainty over the application to end users of the

    significant regulatory requirements for [swap dealers] could lead

    end users to minimize their use of swaps in order to avoid the risk

    of being deemed to be [a swap dealer].''), and Church Alliance

    (stating that the risk of incurring the costs of dealer regulation

    would harm employee benefit plans by reducing their use of swaps and

    security-based swaps for hedging and risk mitigation).

    \150\ See letters from American Bankers Association (``ABA'')

    dated November 3, 2011 (``ABA I''), BOK I, and ISDA I. Section 716

    of the Dodd-Frank Act prohibits any ``swaps entity''--a term that

    encompasses swap dealers and security-based swap dealers--from

    receiving Federal assistance with respect to any swap, security-

    based swap, or other activity of the swaps entity.

    \151\ See letter from API I (stating that costs of regulatory

    uncertainty stem from the use of qualitative factors for identifying

    dealing, and from regulatory efforts to reach beyond ``true'' swap

    dealers); see also letter from Dominion Resources (the opportunity

    costs associated with regulatory uncertainty should be considered).

    ---------------------------------------------------------------------------

    One commenter specifically suggested that in considering the final

    rules, the Commissions should consider empirical data regarding the

    costs and benefits flowing from the rules and issue a second analysis

    of the costs and benefits of the rules for public comment,\152\ while

    other commenters said that the consideration of cost and benefits

    should include the cumulative cost of interrelated regulatory burdens

    arising from all the rules proposed under the Dodd-Frank Act.\153\

    Other commenters said the Commissions should consider alternatives that

    would impose fewer costs.\154\

    ---------------------------------------------------------------------------

    \152\ See letter from WGCEF I.

    \153\ See letters from ABA I, NFPEEU and WGCEF dated December

    20, 2011, enclosing a report prepared by NERA Economic Consulting

    (``NERA'') (``WGCEF VIII''); see also letter from NERA dated March

    13, 2012.

    \154\ See letters from NextEra I (referring to alternative de

    minimis tests) and NFPEEU.

    ---------------------------------------------------------------------------

    Another commenter said that the cost-benefit analyses in the

    Proposing Release may have understated the benefits of the proposed

    rules, because focusing on individual aspects of all the rules proposed

    under the Dodd-Frank Act prevents consideration of the full range of

    benefits that arise from the rules as a whole, in terms of providing

    greater financial stability, reducing systemic risk and avoiding the

    expense of assistance to financial institutions in the future.\155\

    This commenter said the consideration of benefits of the proposed rules

    should include the mitigated risk of a financial crisis.\156\

    ---------------------------------------------------------------------------

    \155\ See letter from Better Markets dated June 3, 2011

    (``Better Markets II'').

    \156\ Better Markets cited estimates that the worldwide cost of

    the 2008 financial crisis in terms of lost output was between $60

    trillion and $200 trillion, depending primarily on the long term

    persistence of the effects. See letter from Better Markets II.

    ---------------------------------------------------------------------------

    3. Final Rules and Interpretation--General Principles

    Consistent with the Proposing Release, the final rules that define

    the terms ``swap dealer'' and ``security-based swap dealer'' closely

    follow the statutory definitions' four tests and exclusion for

    activities that are not part of a ``regular business.'' \157\ In

    addition, this Adopting Release sets forth interpretive guidance

    regarding various elements of the final rules.

    ---------------------------------------------------------------------------

    \157\ See CFTC Regulation Sec. 1.3(ggg)(1), (2); Exchange Act

    rule 3a71-1(a), (b).

    ---------------------------------------------------------------------------

    Because the definitions of the terms ``swap dealer'' in the CEA and

    ``security-based swap dealer'' in the Exchange Act are substantially

    similar, the rules further defining those terms and the accompanying

    interpretations in this Adopting Release reflect common underlying

    principles. At the same time, the interpretations regarding the

    application of the definitions differ in certain respects given the

    differences in the uses of and markets for swaps and security-based

    swaps.\158\ For example, because security-based swaps may be used to

    hedge or gain economic exposure to underlying individual securities

    (while recognizing distinctions between security-based swaps and other

    types of securities, as discussed below), there is a basis to build

    upon the same principles that presently are used to identify dealers

    for other types of securities. These same principles, though

    instructive, may be inapplicable to swaps in certain circumstances or

    may be applied differently in the context of dealing activities

    involving commodity, interest rate, or other types of swaps.

    ---------------------------------------------------------------------------

    \158\ Section 712(a)(7)(A) of the Dodd-Frank Act provides that

    in adopting rules and orders implementing Title VII, the Commissions

    shall treat functionally or economically similar products or

    entities in a similar manner. Section 712(a)(7)(B), though, provides

    that the Commissions need not act in an identical manner.

    ---------------------------------------------------------------------------

    For these reasons, we separately are addressing the interpretation

    of the ``swap dealer'' and ``security-based swap dealer'' definitions.

    Also, as discussed below, the Commissions are directing their

    respective staffs to report separately regarding the rules being

    adopted in connection with the definition and related interpretations.

    These staff reports will help the Commissions evaluate the ``swap

    dealer'' and ``security-based swap dealer'' definitions in all

    respects, including whether new or revised tests or approaches would be

    appropriate for identifying swap dealers and security-based swap

    dealers.\159\

    ---------------------------------------------------------------------------

    \159\ See part V, infra.

    ---------------------------------------------------------------------------

    4. Final Rules and Interpretation--Definition of ``Swap Dealer''

    The Dodd-Frank Act contains a comprehensive definition of the term

    ``swap dealer,'' based upon types of activities. As noted above, we are

    adopting a final rule under the CEA that, like the proposed rule,

    defines the term ``swap dealer'' using terms from the four statutory

    tests and the exclusion for swap activities that are not part of ``a

    regular business.'' \160\ The final rule includes modifications from

    the proposed rule that are described below, including provisions

    stating that swaps entered into for hedging physical positions as

    defined in the rule, swaps between majority-owned affiliates, swaps

    entered into by a cooperative with its members, and certain swaps

    entered into by registered floor traders, are excluded from the swap

    dealer determination.\161\ The Commissions, in consideration of

    comments received, are also making certain modifications to the

    interpretive guidance set out in the Proposing Release with respect to

    various elements of the statutory definition of the term ``swap

    dealer,'' as described below.

    ---------------------------------------------------------------------------

    \160\ See CFTC Regulation Sec. 1.3(ggg)(1), (2).

    \161\ See CFTC Regulation Sec. 1.3(ggg)(6)(ii), (iii).

    ---------------------------------------------------------------------------

    The determination of whether a person is covered by the statutory

    definition of the term ``swap dealer'' requires application of various

    provisions of the rule further defining that term, as well as the

    interpretive guidance in this Adopting Release, depending on the

    person's particular circumstances. We intend that the determination

    with respect to a particular person would proceed as follows.

    The person would begin by applying the statutory definition, and

    the provisions of the rule which implement the four statutory tests and

    the exclusion for swap activities that are not part of ``a regular

    business,'' \162\ in order to determine if the person is engaged in

    swap dealing activity. In that analysis, the person would apply the

    interpretive guidance described in this part II.A.4, which provides for

    consideration of the relevant facts and circumstances. As part of this

    consideration, the person would apply elements of the dealer-trader

    distinction, as appropriate, including as described in part II.A.4.a,

    below.

    ---------------------------------------------------------------------------

    \162\ See CFTC Regulation Sec. 1.3(ggg)(1), (2).

    ---------------------------------------------------------------------------

    The rule provides that certain swaps are not considered in the

    determination of whether a person is a swap dealer.\163\ In particular,

    swaps entered into by an insured depository institution with a customer

    in connection with originating a loan with that customer, \164\ swaps

    [[Page 30607]]

    between majority-owned affiliates, \165\ swaps entered into by a

    cooperative with its members,\166\ swaps entered into for hedging

    physical positions as defined in the rule,\167\ and certain swaps

    entered into by registered floor traders \168\ are excluded from the

    swap dealer determination.

    ---------------------------------------------------------------------------

    \163\ See CFTC Regulation Sec. 1.3(ggg)(5), (6).

    \164\ See CFTC Regulation Sec. 1.3(ggg)(5); see also part II.B,

    infra.

    \165\ See CFTC Regulation Sec. 1.3(ggg)(6)(i); see also part

    II.C, infra.

    \166\ See CFTC Regulation Sec. 1.3(ggg)(6)(ii); see also part

    II.C, infra.

    \167\ See CFTC Regulation Sec. 1.3(ggg)(6)(iii); see also part

    II.B.4.e, infra.

    \168\ See CFTC Regulation Sec. 1.3(ggg)(6)(iv); see also part

    II.B.4.f, infra.

    ---------------------------------------------------------------------------

    If, after completing this review (taking into account the

    applicable interpretive guidance and excluding any swaps as noted

    above), the person determines that it is engaged in swap dealing

    activity, the next step is to determine if the person is engaged in

    more than a de minimis quantity of swap dealing.\169\ If so, the person

    is a swap dealer. When the person registers, it may apply to limit its

    designation as a swap dealer to specified categories of swaps or

    specified activities of the person in connection with swaps.\170\

    ---------------------------------------------------------------------------

    \169\ See CFTC Regulation Sec. 1.3(ggg)(4); see also part II.D,

    infra.

    \170\ See CFTC Regulation Sec. 1.3(ggg)(3); see also part II.E,

    infra.

    ---------------------------------------------------------------------------

    In this part II.A.4., we provide interpretive guidance on the

    application of the ``swap dealer'' definition, modified from the

    Proposing Release as appropriate based on comments received. This

    guidance separately addresses the following: application of the dealer-

    trader framework; the ``holding out'' and ``commonly known'' criteria;

    market making; the not part of ``a regular business'' exception; the

    exclusion of swaps entered into for hedging physical positions as

    defined in the rule; and the overall interpretive approach to the

    definition.\171\

    ---------------------------------------------------------------------------

    \171\ The Commissions note that interpretations of the

    applicability of the dealer-trader distinction to the ``swap

    dealer'' definition under the CEA do not affect existing, or future,

    interpretations of the dealer-trader distinction under the Exchange

    Act.

    ---------------------------------------------------------------------------

    a. Use of the Dealer-Trader Distinction

    We believe that the dealer-trader distinction \172\--which already

    forms a basis for identifying which persons fall within the

    longstanding Exchange Act definition of ``dealer''--in general provides

    an appropriate framework for interpreting the statutory definition of

    the term ``swap dealer.'' \173\ While there are differences in the

    structure of those two statutory definitions,\174\ we believe that

    their parallels--particularly their exclusions for activities that are

    ``not part of a regular business''--warrant analogous interpretive

    approaches for distinguishing dealers from non-dealers.\175\ Thus, the

    dealer-trader distinction forms the basis for a framework that

    appropriately distinguishes between persons who should be regulated as

    swap dealers and those who should not. We also believe that the

    distinction affords an appropriate degree of flexibility to the

    analysis, and that it would not be appropriate to seek to codify the

    distinction in rule text.

    ---------------------------------------------------------------------------

    \172\ See note 31, supra. The principles embedded within the

    ``dealer-trader distinction'' are also applicable to distinguishing

    dealers from non-dealers such as hedgers or investors. See note 250,

    infra.

    \173\ The Commissions note that interpretations of the

    applicability of the dealer-trader distinction to the ``swap

    dealer'' definition under the CEA do not affect existing, or future,

    interpretations of the dealer-trader distinction under the Exchange

    Act.

    \174\ For example, while the ``dealer'' definition encompasses

    certain persons in the business of ``buying and selling''

    securities, the ``swap dealer'' definition does not address either

    ``buying'' or ``selling.'' We also note that the ``dealer''

    definition requires the conjunctive ``buying and selling''--which

    connotes a degree of offsetting two-sided activity. In contrast, the

    swap dealer definition (particularly the ``regularly enters into''

    swaps language of the definition's third prong) lacks that

    conjunctive terminology.

    \175\ In the Proposing Release, the CFTC did not propose to use

    principles from the dealer-trader distinction to interpret the

    definition of the term ``swap dealer,'' instead proposing an

    interpretive approach that focused on, among other things, a

    person's functional role in the swap markets and its relationships

    with swap counterparties. See Proposing Release, 75 FR at 80177.

    There was, however, some overlap in practice between the factors

    identified in the Proposing Release relating to a swap dealer's

    functional role and relationships and the principles of the dealer-

    trader distinction that were proposed to be applied to identify

    security-based swap dealers. Moreover, the changes to the

    interpretive approach to the swap dealer definition that we are

    adopting here and discussed in this part II.A.4 are in many respects

    similar to the principles of the dealer-trader distinction. We also

    acknowledge the commenters who asked for additional guidance

    regarding the application of the definitions. See, e.g., letters

    from Gavilon II, Peabody and the Utility Group, and meeting with

    CDEU on April 7, 2011.

    Thus, while the incorporation of the dealer-trader distinction

    in the interpretation of the term ``swap dealer'' constitutes a

    change from the Proposing Release, this is simply reflective of the

    other changes to the CFTC's interpretive approach that we are

    adopting for the final rule and the overlap between the factors

    relating to a swap dealer's functional role and counterparty

    relationships and the principles of the dealer-trader distinction.

    ---------------------------------------------------------------------------

    The Commissions recognize that the dealer-trader distinction needs

    to be adapted to apply to swap activities in light of the special

    characteristics of swaps and the differences between the ``dealer''

    definition, on the one hand, and the ``swap dealer'' definition, on the

    other. Relevant differences between the swap market and the markets for

    securities (other than security-based swaps) include:

    Level of activity--Swap markets are marked by less

    activity than markets involving certain types of securities (while

    recognizing that some debt and equity securities are not actively

    traded). This suggests that in the swap context, concepts of

    ``regularity'' should account for a participant's level of activity in

    the market relative to the total size of the market.

    No separate issuer--Each counterparty to a swap in essence

    is the ``issuer'' of that instrument; in contrast, dealers in cash

    market securities generally transact in securities issued by another

    party. This distinction suggests that the concept of maintaining an

    ``inventory'' of securities is inapposite in the context of swaps.

    Moreover, this distinction--along with the fact that the ``swap

    dealer'' definition lacks the conjunctive ``buying and selling''

    language of the ``dealer'' definition--suggests that concepts of two-

    sided markets at times would be less relevant for identifying swap

    dealers than they would be for identifying dealers.\176\

    ---------------------------------------------------------------------------

    \176\ The analysis also should account for the fact that a party

    to a swap can use other derivatives or cash market instruments to

    hedge the risks associated with the swap position, meaning that two-

    way trading is not necessary to maintain a flat risk book.

    ---------------------------------------------------------------------------

    Predominance of over-the-counter and non-standardized

    instruments--Swaps an thus far are not significantly traded on

    exchanges or other trading systems, in contrast to some cash market

    securities (while recognizing that many cash market securities also are

    not significantly traded on those systems).\177\ These attributes--

    along with the lack of ``buying and selling'' language in the swap

    dealer definition, as noted above--suggest that concepts of what it

    means to make a market need to be construed flexibly in the contexts of

    the swap markets.

    ---------------------------------------------------------------------------

    \177\ Even though we expect trading of swaps on exchanges

    following the implementation of Title VII, we expect there to remain

    a significant amount of over-the-counter activity involving swaps.

    ---------------------------------------------------------------------------

    Mutuality of obligations and significance to ``customer''

    relationship--In contrast to a secondary market transaction involving

    equity or debt securities, in which the completion of a purchase or

    sale transaction can be expected to terminate the mutual obligations of

    the parties to the transaction, the parties to a swap often will have

    an ongoing obligation to exchange cash flows over the life of the

    agreement. In light of this attribute, some market participants have

    expressed the view that they have ``counterparties'' rather than

    ``customers'' in the context of their swap activities.

    In applying the dealer-trader distinction, it also is necessary to

    apply

    [[Page 30608]]

    the statutory provisions that will govern swap dealers in an effective

    and logical way. Those statutory provisions added by the Dodd-Frank Act

    advance financial responsibility (e.g., the ability to satisfy

    obligations, and the maintenance of counterparties' funds and assets)

    associated with swap dealers' activities,\178\ other counterparty

    protections,\179\ and the promotion of market efficiency and

    transparency.\180\ As a whole, the relevant statutory provisions

    suggest that we should interpret the ``swap dealer'' definition to

    identify those persons for which regulation is warranted either: (i)

    Due to the nature of their interactions with counterparties; or (ii) to

    promote market stability and transparency, in light of the role those

    persons occupy within the swap and security-based swap markets.

    ---------------------------------------------------------------------------

    \178\ E.g., capital and margin requirements (CEA section 4s(e)),

    and requirements for segregation of collateral (CEA sections 4d(f),

    4s(l)).

    \179\ E.g., requirements with respect to business conduct when

    transacting with special entities (CEA sections 4s(h)(2), 4s(h)(4),

    4s(h)(5)); disclosure requirements (CEA section 4s(h)(3)(B));

    requirements for fair and balanced communications (CEA section

    4s(h)(3)(D)); other requirements related to the public interest and

    investor protection (CEA section 4s(h)(3)(D)); and conflict of

    interest provisions (CEA section 4s(j)(5)).

    \180\ E.g., reporting and recordkeeping requirements (CEA

    section 4s(f)); daily trading records requirements (CEA section

    4s(g)); regulatory standards related to the confirmation,

    processing, netting, documentation and valuation of security-based

    swaps (CEA section 4s(i)); position limit monitoring requirements

    (CEA section 4s(j)(1)); risk management procedure requirements (CEA

    section 4s(j)(2)); and requirements related to the disclosure of

    information to regulators (CEA section 4s(j)(3)).

    ---------------------------------------------------------------------------

    There are several aspects of our interpretive approach to the swap

    dealer definition that are particularly similar to the dealer-trader

    distinction as it will be applied to determine if a person is a

    security-based swap dealer. In particular, the following activities,

    which are indicative of dealing activity in the application of the

    dealer-trader distinction,\181\ similarly are indicative that a person

    is acting as a swap dealer: \182\ (i) Providing liquidity by

    accommodating demand for or facilitating interest in the instrument

    (swaps, in this case), holding oneself out as willing to enter into

    swaps (independent of whether another party has already expressed

    interest), or being known in the industry as being available to

    accommodate demand for swaps; (ii) advising a counterparty as to how to

    use swaps to meet the counterparty's hedging goals, or structuring

    swaps on behalf of a counterparty; (iii) having a regular clientele and

    actively advertising or soliciting clients in connection with swaps;

    \183\ (iv) acting in a market maker capacity on an organized exchange

    or trading system for swaps; \184\ and (v) helping to set the prices

    offered in the market (such as by acting as a market maker) rather than

    taking those prices, although the fact that a person regularly takes

    the market price for its swaps does not foreclose the possibility that

    the person may be a swap dealer.

    ---------------------------------------------------------------------------

    \181\ See generally part II.A.5, infra.

    \182\ To clarify, the activities listed in the text are

    indicative of acting as a swap dealer. Engaging in one or more of

    these activities is not a prerequisite to a person being covered by

    the swap dealer definition.

    \183\ As with the interpretation of the dealer-trader

    distinction with respect to securities, a nomenclature distinction

    between ``counterparties'' and ``customers'' is not significant for

    purposes of applying the dealer-trader distinction to swap

    activities. Contractual provisions related to nomenclature, such as

    a provision stating that no ``customer'' relationship is present,

    would not be significant if the reality of the situation is

    different. See note 271, infra, and accompanying text.

    \184\ As with the dealer-trader distinction as it has been

    interpreted under the Exchange Act with respect to securities (and

    as noted below in the discussion of the ``makes a market in swaps''

    prong of the swap dealer definition), the presence of an organized

    exchange or trading system is not a prerequisite to being a market

    maker for purposes of the swap dealer definition, nor is acting as a

    market maker a prerequisite to being a swap dealer.

    ---------------------------------------------------------------------------

    The Commissions further note that the following elements of the

    interpretive approach to the swap dealer definition are also generally

    consistent with the dealer-trader distinction as it will be applied to

    determine if a person is a security-based swap dealer: (i) A

    willingness to enter into swaps on either side of the market is not a

    prerequisite to swap dealer status; (ii) the swap dealer analysis does

    not turn on whether a person's swap dealing activity constitutes that

    person's sole or predominant business; (iii) a customer relationship is

    not a prerequisite to swap dealer status; and (iv) in general, entering

    into a swap for the purpose of hedging, absent other activity, is

    unlikely to be indicative of dealing. Last, under the interpretive

    approach to the definition of both the terms ``swap dealer'' and

    ``security-based swap dealer,'' whether a person is acting as a dealer

    will turn upon the relevant facts and circumstances, as informed by the

    interpretive guidance set forth in this Adopting Release.

    At the same time, the Commissions recognize that the dealer-trader

    distinction is not static, but rather has evolved over time through

    interpretive materials. The Commissions expect the dealer-trader

    distinction to evolve over time with respect to swaps independently of

    its evolution over time with respect to securities or security-based

    swaps. Prior interpretations and future developments in the law

    regarding securities or security-based swaps may inform the

    interpretation of the swap dealer definition, but will not be

    dispositive in identifying dealers in the swap markets.\185\

    ---------------------------------------------------------------------------

    \185\ In interpreting the term ``swap dealer,'' we intend to

    consider, but do not formally adopt, the body of court decisions,

    SEC releases, and SEC staff no-action letters that have interpreted

    the dealer-trader distinction.

    ---------------------------------------------------------------------------

    b. Indicia of Holding Oneself Out as a Dealer in Swaps or Being

    Commonly Known in the Trade as a Dealer in Swaps

    The final rule further defining the term ``swap dealer'' includes

    the provisions in the proposed rule which incorporate the statutory

    requirements that the term includes a person that is holding itself out

    as a dealer in swaps or is engaging in any activity causing it to be

    commonly known in the trade as a dealer or market maker in swaps.\186\

    ---------------------------------------------------------------------------

    \186\ See CFTC Regulation Sec. 1.3(ggg)(1)(i) and (iv).

    ---------------------------------------------------------------------------

    We continue to believe that the Proposing Release appropriately

    identifies a number of factors as indicia of ``hold[ing] itself out as

    a dealer in swaps'' and ``engag[ing] in any activity causing [itself]

    to be commonly known in the trade as a dealer or market maker in

    swaps.'' \187\ In our view, those factors thus are relevant to

    determining if a person is a swap dealer. For example, regarding the

    proposed factor of ``membership in a swap association in a category

    reserved for dealers,'' we note that the bylaws of the International

    Swaps and Derivatives Association (``ISDA'') provide that any business

    organization that:

    \187\ These factors are as follows: Contacting potential

    counterparties to solicit interest; developing new types of swaps or

    security-based swaps and informing potential counterparties of their

    availability and of the person's willingness to enter into the swap

    or security-based swap; membership in a swap association in a

    category reserved for dealers; providing marketing materials

    describing the type of swaps or security-based swaps the party is

    willing to enter into; and generally expressing a willingness to

    offer or provide a range of products or services that include swaps

    or security-based swaps. See Proposing Release, 75 FR at 80178.

    Directly or through an affiliate, as part of its business

    (whether for its own account or as agent), deals in derivatives

    shall be eligible for election to membership in the Association as a

    Primary Member, provided that no person or entity shall be eligible

    for membership as a Primary Member if such person or entity

    participates in derivatives transactions solely for the purpose of

    risk hedging or asset or liability management.\188\

    ---------------------------------------------------------------------------

    \188\ See By-laws of ISDA at 3, available at: https://www.isdadocs.org/membership. The Commissions note that the Primary

    Members of ISDA are not limited to only financial firms.

    We believe that in circumstances such as this, where a category of

    association

    [[Page 30609]]

    membership requires that a person deal in derivatives and not limit its

    participation in derivative transactions to solely risk hedging,

    membership in the category is an indicator of swap dealer status.\189\

    ---------------------------------------------------------------------------

    \189\ However, while such membership is an indicator of swap

    dealer status, a person holding such membership could nonetheless be

    excluded by other provisions of the definition of the term ``swap

    dealer.'' For example, an insured depository institution that limits

    its activity to offering swaps in connection with the origination of

    loans, as discussed below in part II.B, would not be covered by the

    definition simply because it holds such membership.

    ---------------------------------------------------------------------------

    We take note, however, of the comments that these activities may be

    insufficient to establish that a person is a swap dealer. In

    particular, we generally agree with commenters that many commercial end

    users of swaps do, from time to time, actively seek out and negotiate

    swaps. Yet, based on the applicable facts and circumstances, these end

    users do not necessarily fall within the definition of a swap dealer

    solely because they actively seek out and negotiate swaps from time to

    time.

    The activities described in the Proposing Release as indicia of

    holding oneself out as a swap dealer or engaging in any activity

    causing oneself to be commonly known as a swap dealer should not be

    considered in a vacuum, but should instead be considered in the context

    of all the activities of the swap participant. While the activities

    listed in the Proposing Release are indicators that a person is holding

    itself out or is commonly known as a swap dealer, these are factors to

    be considered in the analysis. They are not per se conclusive, and

    could be countered by other factors indicating that the person is not a

    swap dealer.\190\ Because of the flexibility--including the

    consideration of applicable facts and circumstances--needed for such an

    analysis, we do not believe that it is appropriate to codify this

    guidance in rule text, as suggested by some commenters.

    ---------------------------------------------------------------------------

    \190\ The statutory definition of the term ``swap dealer''

    contains four separate clauses, or ``prongs,'' joined by the

    disjunctive ``or,'' the ordinary meaning of which is that the prongs

    are stated as alternative types of swap dealer. Accordingly, where

    an assessment of all the activities of a swap participant

    demonstrates that the person is not holding itself out as a swap

    dealer or engaging in any activity that causes it to be commonly

    known as a swap dealer, that person may, nonetheless, be a swap

    dealer based on the market making or regular business prongs of the

    swap dealer definition, discussed below. The Commissions note,

    however, that as discussed below in part II.A.4.g, the CFTC's

    overall interpretive guidance, including guidance regarding the

    dealer-trader framework, applies to identify swap dealers under all

    four prongs of the statutory ``swap dealer'' definition.

    ---------------------------------------------------------------------------

    c. Market Making

    The final rule defining ``swap dealer'' includes the provision from

    the proposed rule which incorporates the statutory requirement that

    this term include a person that ``makes a market in swaps.'' \191\

    ---------------------------------------------------------------------------

    \191\ See CFTC Regulation Sec. 1.3(ggg)(1)(ii). Because the

    statutory swap dealer definition contains four disjunctive prongs,

    the CFTC does not agree with a commenter (see letter from ISDA I)

    who asserted that status as a market maker in swaps is a

    prerequisite to a person being a swap dealer.

    ---------------------------------------------------------------------------

    We have considered the comments suggesting various descriptions of

    activities that should and should not be deemed to be market making in

    swaps for purposes of this rule. In consideration of these comments, we

    clarify that making a market in swaps is appropriately described as

    routinely standing ready to enter into swaps at the request or demand

    of a counterparty. In this regard, ``routinely'' means that the person

    must do so more frequently than occasionally, but there is no

    requirement that the person do so continuously.\192\

    ---------------------------------------------------------------------------

    \192\ A person that occasionally, or less than routinely, enters

    into a swap at the request of a counterparty is not a maker of a

    market in swaps, and therefore is not a swap dealer on that basis.

    However, we reiterate, as stated in the Proposing Release, that

    since many types of swaps are not entered into on a continuous

    basis, it is not necessary that a person enter into swaps at the

    request or demand of counterparties on a continuous basis in order

    for the person to be a market maker in swaps and, therefore, a swap

    dealer.

    ---------------------------------------------------------------------------

    It is appropriate, in response to comments asking for further

    guidance regarding what activities constitute making a market in swaps,

    to describe some of the activities indicative of whether a person is

    routinely standing ready to enter into swaps at the request or demand

    of a counterparty. Such activities include routinely: (i) Quoting bid

    or offer prices, rates or other financial terms for swaps on an

    exchange; (ii) responding to requests made directly, or indirectly

    through an interdealer broker, by potential counterparties for bid or

    offer prices, rates or other similar terms for bilaterally negotiated

    swaps; (iii) placing limit orders for swaps; or (iv) receiving

    compensation for acting in a market maker capacity on an organized

    exchange or trading system for swaps.\193\ These examples are not

    exhaustive, and other activities also may be indicative of making a

    market in swaps if the person engaging in them routinely stands ready

    to enter into swaps as principal at the request or demand of a

    counterparty.

    ---------------------------------------------------------------------------

    \193\ In addition, section 619 of the Dodd-Frank Act (the

    ``Volcker Rule'') generally prohibits banking entities from engaging

    in proprietary trading, but contains an exception for certain market

    making-related activities. The Commissions have proposed an approach

    to the Volcker Rule under which a person could seek to avoid the

    Volcker Rule in connection with swap activities by asserting the

    availability of that market making exception. See SEC, Board, Office

    of the Comptroller of the Currency (``OCC''), and Federal Deposit

    Insurance Corporation (``FDIC''), Prohibitions and Restrictions on

    Proprietary Trading and Certain Interests in, and Relationships

    With, Hedge Funds and Private Equity Funds; Proposed Rule, 76 FR

    68846 (Nov. 7, 2011); CFTC, Prohibitions and Restrictions on

    Proprietary Trading and Certain Interests in, and Relationships

    With, Hedge Funds and Private Equity Funds; Proposed Rule, 77 FR

    8332 (Feb. 14, 2012). Under this approach, such a person would

    likely also be required to register as a swap dealer (unless the

    person is excluded from the swap dealer definition, such as by the

    exclusion of certain swaps entered into in connection with the

    origination of a loan). The SEC has proposed to adopt the same

    approach with respect to the interplay of the Volcker Rule and the

    definition of the term ``security-based swap dealer.'' See note 272,

    infra.

    ---------------------------------------------------------------------------

    In determining whether a person's routine presence in the market

    constitutes market making under these four factors, the dealer-trader

    interpretative framework may be usefully applied.\194\ Under the

    dealer-trader distinction, seeking to profit by providing liquidity to

    the market is an indication of dealer activity.\195\ Thus, in applying

    these four factors, it is useful to consider whether the person is

    seeking, through presence in the market, compensation for providing

    liquidity, compensation through spreads or fees, or other compensation

    not attributable to changes in the value of the swaps it enters

    into.\196\ If not, such activity would not be indicative of market

    making.

    ---------------------------------------------------------------------------

    \194\ We recognize that routine presence in the swap market is

    not necessarily indicative of making a market in swaps. For example,

    persons may be routinely present in the market in order to engage in

    swaps for purposes of hedging, to advance their investment

    objectives, or to engage in proprietary trading.

    \195\ See note 265, infra, and accompanying text.

    \196\ In this case, the spread from which a person profits may

    be between two or more swaps, or it may be between a swap and

    another position or financial instrument. In contrast, entering into

    swaps in order to obtain compensation attributable to changes in the

    value of the swaps is indicative of using swaps for a hedging,

    investment or trading purpose.

    ---------------------------------------------------------------------------

    Some commenters suggested that, in order to be a market maker in

    swaps, a person must make a two-way market in swaps.\197\ Nonetheless,

    it is possible for a person making a one-way market in swaps to be a

    maker of a market in swaps and, therefore, within the swap dealer

    definition. This may be true, for example, where a person routinely

    [[Page 30610]]

    stands ready to enter into swaps on a particular side of the market--

    say, routinely bidding for floating exposures on a swap trading

    platform--while entering into transactions on the other side of the

    market in other instruments (such as futures contracts). The relevant

    indicator of market maker status is the willingness of the person to

    routinely stand ready to enter into swaps at the request or demand of a

    counterparty (as opposed to entering into swaps to accommodate one's

    own demand or desire to participate in a particular market), be it on

    one or both sides of the market, and then to enter into offsetting

    positions, either in the swap market or in other markets.

    ---------------------------------------------------------------------------

    \197\ See letters cited in notes 52 to 58, supra. Although swaps

    are notional contracts requiring the performance of agreed upon

    terms by each party, it is possible to describe swap users in

    practical terms as being on either ``side'' of a market. For

    example, for many swaps the party paying a fixed amount is on one

    ``side'' of the market and the party paying a floating amount is on

    the other ``side.''

    ---------------------------------------------------------------------------

    The Commissions disagree with the commenters who said that swaps

    executed on an exchange should not be considered in determining if a

    person is a market maker in swaps and thus a swap dealer.\198\ First,

    the statutory definition of the term ``swap dealer'' makes no

    distinction between swaps executed on an exchange and swaps that are

    not, suggesting that the same protections should apply regardless of

    the method of executing the swap. Second, from the perspective of an

    end user seeking to execute a swap on an exchange, the important

    consideration under our analysis is whether a market maker is ready to

    enter into swaps, not whether the market maker is aware of the

    counterparty's identity. A market maker in swaps routinely stands ready

    to enter into swaps at the request or demand of a counterparty,

    regardless of whether the counterparty and the market maker meet on a

    disclosed basis through bilateral negotiations or anonymously through

    an exchange.\199\ Similarly, the issue of whether a person is a

    registered FCM or broker-dealer is not necessarily relevant to whether

    the person is a maker of a market in swaps, if the person is routinely

    standing ready to enter into swaps at the request or demand of a

    counterparty. Third, we believe it would be inappropriate to disregard

    swaps executed on exchanges in order, as some commenters

    suggested,\200\ to encourage market participants to use, or to provide

    liquidity to, exchanges. Finally, variety of exchanges, markets, and

    other facilities for the execution of swaps are likely to evolve in

    response to the requirements of the Dodd-Frank Act, and there is no

    basis for any bright-line rule excluding swaps executed on an exchange,

    given the impossibility of obtaining information about how market

    participants will interact and execute swaps in the future, after the

    requirements under the Dodd-Frank Act are fully in effect. For all

    these reasons, we have determined that it is inappropriate to restrict

    the ``making a market in swaps'' prong of the swap dealer definition

    (i.e., routinely standing ready to enter into swaps at the request or

    demand of a counterparty) to swaps that are not executed on an

    exchange.\201\

    ---------------------------------------------------------------------------

    \198\ See, e.g., letters cited in note 62, supra.

    \199\ As discussed above, in many cases routine presence in the

    swap market, without more, would not constitute market making

    activity. Nevertheless, the CFTC will, in connection with

    promulgation of final rules relating to capital requirements for

    swap dealers and major swap participants, consider institution of

    reduced capital requirements for entities or individuals that fall

    within the swap dealer definition and that execute swaps only on

    exchanges, using only proprietary funds. Similarly, the CFTC also

    will consider the applicability to such entities or individuals of

    the other requirements imposed on swap dealers (e.g., internal

    business conduct standards, external business conduct standards with

    counterparties), and may adjust those swap dealer requirements as

    appropriate.

    \200\ See, e.g., letters cited in note 66, supra. Since the

    structures of the markets on which swaps will be executed are still

    in development, and market obligations have not been established,

    there is little support for comments asserting that market makers

    should be defined as only those persons who receive benefits from

    the market (such as reduced trading fees) in return for the

    obligation to transact when the market requires liquidity.

    \201\ By contrast, it may be appropriate, over time, to tailor

    the specific requirements imposed on swap dealers depending on the

    facility on which the swap dealer executes swaps. For example, the

    application of certain business conduct requirements may vary

    depending on how the swap is executed, and it may be appropriate, as

    the swap markets evolve, to consider adjusting certain of those

    requirements for swaps that are executed on an exchange or through

    particular modes of execution.

    ---------------------------------------------------------------------------

    d. Exception for Activities Not Part of ``a Regular Business''

    The final rule includes the provisions in the proposed rule that

    incorporate the provisions of the statutory definition regarding

    activities that are not part of ``a regular business'' of entering into

    swaps. One provision states that the term ``swap dealer'' includes a

    person that ``regularly enters into swaps with counterparties as an

    ordinary course of business for its own account''; the other provision

    states that the term ``swap dealer'' does not include a person that

    ``enters into swaps for such person's own account, either individually

    or in a fiduciary capacity, but not as a part of a regular business.''

    \202\

    ---------------------------------------------------------------------------

    \202\ Final CFTC Regulation Sec. 1.3(ggg)(2) is modified from

    the proposal to include the word ``a'' before the words ``regular

    business,'' to conform the text of the rule to the text of the

    statute. See CEA section 1a(49)(C), 7 U.S.C. 1a(49)(C).

    As stated in the Proposing Release, we interpret the reference

    in the definition of the term ``swap dealer'' to a person entering

    into swaps ``with counterparties * * * for its own account'' to

    refer to a person who enters into a swap as a principal, and not as

    an agent. A person who enters into swaps as an agent for customers

    (i.e., for the customers' accounts) would be required to register as

    either an FCM, introducing broker, commodity pool operator or

    commodity trading advisor, depending on the nature of the person's

    activity.

    ---------------------------------------------------------------------------

    The Commissions continue to believe, as stated in the Proposing

    Release, that the phrases ``ordinary course of business'' and ``a

    regular business'' are, for purposes of the definition of ``swap

    dealer'' essentially synonymous. In this context, we interpret these

    phrases to focus on activities of a person that are usual and normal in

    the person's course of business and identifiable as a swap dealing

    business. It is not necessarily relevant whether the person conducts

    its swap-related activities in a dedicated subsidiary, division,

    department or trading desk, or whether such activities are a person's

    ``primary'' business or an ``ancillary'' business, so long as the

    person's swap dealing business is identifiable.\203\

    ---------------------------------------------------------------------------

    \203\ We recognize, as noted by one commenter (see letter from

    ISDA I), that the ``regular business'' exclusion is not limited

    solely to the ``ordinary course of business'' test of the swap

    dealer definition. Our interpretations of the other three tests are,

    and should be read to be, consistent with the exclusion of

    activities that are not part of a regular business.

    ---------------------------------------------------------------------------

    We have taken into consideration comments seeking additional

    guidance regarding the types and levels of activities that constitute

    having ``a regular business'' of entering into swaps.\204\ In this

    regard, any one of the following activities would generally constitute

    both entering into swaps ``as an ordinary course of business'' and ``as

    a part of a regular business'': \205\ (i) Entering into swaps with the

    purpose of satisfying the business or risk management needs of the

    counterparty (as opposed to entering into swaps to accommodate one's

    own demand or desire to participate in a particular market); (ii)

    maintaining a separate profit and loss statement reflecting the results

    of swap activity or treating swap activity as a separate profit center;

    or (iii) having staff and resources allocated to dealer-type activities

    with counterparties, including activities relating to credit analysis,

    customer onboarding, document negotiation, confirmation generation,

    requests for novations and amendments, exposure monitoring and

    collateral calls, covenant monitoring, and reconciliation.\206\

    ---------------------------------------------------------------------------

    \204\ See, e.g., letters from BG LNG I, COPE I, IECA-Credit I,

    Shell Trading I, WGCEF I and Vitol (stating that the proposed

    approach was overly subjective and requesting guidance as to the

    specific activities that are covered by the statutory definition).

    \205\ These activities are inconsistent with entering into a

    swap to hedge a physical position as defined in Sec.

    1.3(ggg)(6)(iii). As discussed below, such hedging is not dealing

    activity.

    \206\ The three indicators of being engaged in ``a regular

    business'' of entering into swaps described here are set forth in

    the alternative. Any one of these indicators may be sufficient,

    based on a facts and circumstances analysis, to reach a conclusion

    that an entity is engaged in ``a regular business'' of entering into

    swaps.

    ---------------------------------------------------------------------------

    [[Page 30611]]

    The Commissions see merit in the comments saying that ``a regular

    business'' of entering into swaps can be characterized by entering into

    swaps to satisfy the business or risk management needs of the other

    party to the swap, and so incorporate this element into our

    interpretation of the rule.\207\ Also, an objective indicator of a

    person being engaged in ``a regular business'' of entering into swaps

    is when the person accounts for the results of its swap activities

    separately, by maintaining a separate profit and loss statement for

    those activities or treating them as a separate profit center. Our

    interpretation incorporates this indicator of activity that is ``a

    regular business'' of entering into swaps.

    ---------------------------------------------------------------------------

    \207\ This element of the interpretation reflects our agreement

    with those commenters who said that ``a regular business'' of

    entering into swaps is characterized by having a business of

    accommodating demand or facilitating interest in swaps (see letter

    from IECA-Credit I), and those commenters who said that ``a regular

    business'' does not encompass the use of swaps to serve a person's

    own business needs, as opposed to serving the business needs of the

    counterparty (see letters cited in note 71, supra).

    ---------------------------------------------------------------------------

    Other comments suggesting specific criteria to identify ``a regular

    business'' also were helpful. We agree with commenters \208\ that ``a

    regular business'' of entering into swaps can be characterized by

    having staff and resources allocated to the types of activities in

    which swap dealers must engage with their counterparties, such as those

    noted above (e.g., credit analysis, confirmation generation, collateral

    calls, and covenant monitoring). However, we understand that some end

    users of swaps engage in some of these activities and, in certain

    circumstances, may have staff and resources available for these

    activities. Therefore, this element of the definition should be applied

    in a reasonable manner, taking all appropriate circumstances into

    account. This element does not depend on whether a specific amount or

    percentage of expenses or employee time are related to these swap

    activities. Instead, it is appropriate to objectively examine a

    person's use of staff and resources related to swap activities. Using

    staff and resources to a significant extent in conducting credit

    analysis, opening and monitoring accounts and the other activities

    noted above, is an indication that the person is engaged in ``a regular

    business'' of entering into swaps.

    ---------------------------------------------------------------------------

    \208\ See letters cited in note 80, supra.

    ---------------------------------------------------------------------------

    Regarding the commenters' assertion that the activity of entering

    into swaps in connection with a person's physical commodity business

    cannot constitute ``a regular business'' of the person, we believe that

    while in most cases this is not dealing activity,\209\ a per se

    exclusion of this type is not appropriate because it is possible that

    in some circumstances a person might enter into swaps that are

    connected to a physical commodity business but also serve market

    functions characteristic of the functions served by swap dealers. Also,

    again, the statutory definition does not contain any such exclusion,

    but rather includes any person who ``regularly enters into swaps with

    counterparties as an ordinary course of business for its own account,''

    without regard to the person's particular type of business.

    ---------------------------------------------------------------------------

    \209\ See CFTC Regulation Sec. 1.3(ggg)(6)(iii) (swaps entered

    into for hedging physical positions as defined in the rule are not

    considered in the determination of whether a person is a swap

    dealer).

    ---------------------------------------------------------------------------

    Consistent with the statutory definition, we interpret ``a regular

    business'' of entering into swaps in a manner that applies equally to

    all market participants that engage in the activities set forth in the

    statutory definition. This will ensure that all participants in the

    swap markets are regulated in a fair and consistent manner, regardless

    of whether their underlying business is primarily physical or financial

    in nature.\210\

    ---------------------------------------------------------------------------

    \210\ Regulation of firms engaged in an underlying physical

    business is also consistent with regulatory practices outside the

    U.S. For example, non-financial entities register with the Financial

    Services Authority in the U.K. as ``Oil Market Participants'' and

    ``Energy Market Participants.'' See Financial Services Authority

    Handbook EMPS and OMPS, available at http://fsahandbook.info/FSA/html/handbook.

    ---------------------------------------------------------------------------

    Finally, as noted above, the manner in which persons negotiate,

    execute and use swaps is likely to evolve in response to the

    requirements of the Dodd-Frank Act and the other forces that will shape

    the swap markets going forward. For this reason, it would be

    inappropriate to craft per se exclusions from the swap dealer

    definition at a time when the only available information about the use

    of swaps relates to the period prior to implementation of the Dodd-

    Frank Act.\211\

    ---------------------------------------------------------------------------

    \211\ For the same reasons, we do not believe it would be

    appropriate, in determining whether a person has a ``regular

    business'' of entering into swaps, to consider whether a person

    engages in activities normally associated with financial

    institutions, as some commenters suggested. See letters cited in

    note 76, supra.

    ---------------------------------------------------------------------------

    e. Interim Final Rule Excluding Swaps Entered Into for Hedging Physical

    Positions

    We note that some commenters said that swaps used to hedge or

    mitigate commercial risks should not be considered in determining

    whether a person is a swap dealer.\212\ We understand that swaps are

    used to hedge risks in numerous and varied ways, and we expect that the

    number of persons covered by the definition will be very small in

    comparison to the thousands of persons that use swaps for hedging.

    ---------------------------------------------------------------------------

    \212\ See, e.g., letters cited in note 72, supra.

    ---------------------------------------------------------------------------

    In terms of the statutory definition of the term ``swap dealer,''

    the CFTC notes as an initial matter that there is no specific provision

    addressing hedging activity. Thus, the statutory definition leaves the

    treatment of hedging swaps to the CFTC's discretion; it neither

    precludes consideration of a swap's hedging purpose, nor does it

    require an absolute exclusion of all swaps used for hedging.\213\

    ---------------------------------------------------------------------------

    \213\ In this regard, the statutory definition of the term

    ``swap dealer'' stands in contrast to the statutory definition of

    the term ``major swap participant'' which, as discussed further

    below, explicitly provides that positions in swaps held for hedging

    or mitigating commercial risk are to be excluded in certain parts of

    that definition. See CEA section 1a(33)(A)(i)(1), 7 U.S.C.

    1a(33)(A)(i)(1). The absence of any explicit requirement in the

    ``swap dealer'' definition to exclude swaps held for hedging or

    mitigating commercial risk does not support the view that Congress

    intended to categorically exclude all swaps that may serve as hedges

    in determining whether a person is covered by the definition.

    Similarly, the absence of any limitation in the statutory

    definition of the term ``swap dealer'' to financial entities, when

    such limitation is included elsewhere in Title VII, indicates that

    no such limitation applies to the swap dealer definition. CEA

    section 2(h)(7), 7 U.S.C. 2(h)(7), specifically limits the

    application of the clearing mandate, in certain circumstances, to

    only ``financial entities.'' That section also provides a detailed

    definition of the term ``financial entity.'' See CEA section

    2(h)(7)(C), 7 U.S.C. 2(h)(7)(C). That such a limitation is included

    in this section, but not in the swap dealer definition, does not

    support the view that the statutory definition of the term ``swap

    dealer'' should encompass only financial entities.

    ---------------------------------------------------------------------------

    In general, entering into a swap for the purpose of hedging is

    inconsistent with swap dealing.\214\ The practical

    [[Page 30612]]

    difficulty lies in determining when a person has entered into a swap

    for the purpose of hedging, as opposed to other purposes for entering

    into swaps, such as accommodating demand for swaps or as part of making

    a market in swaps, and in distinguishing a swap with a hedging purpose

    from a swap with a hedging consequence. In view of these uncertainties,

    the CFTC believes it is appropriate to adopt an interim final rule that

    draws upon the principles of bona fide hedging that the CFTC has long

    applied to identify when a financial instrument is used for hedging

    purposes, and excludes from the swap dealer analysis swaps entered into

    for the purpose of hedging physical positions that meet the

    requirements of the rule.

    ---------------------------------------------------------------------------

    \214\ For example, under the dealer-trader distinction, the

    Commissions would expect persons that use security-based swaps to

    hedge their business risks, absent other activity, likely would not

    be dealers. See part II.A.5.b, infra. Under the CFTC's interpretive

    guidance, making a market in swaps is appropriately described as

    routinely standing ready to enter into swaps at the request or

    demand of a counterparty, and the indicia of swap dealing as a

    ``regular business'' include entering into swaps to satisfy the

    business or risk management needs of the counterparty. Entering into

    swaps for the purpose of hedging one's own risks generally would not

    be indicative of this form of swap activity. See also, e.g., joint

    letter from Senator Stabenow and Representative Lucas (the final

    rule should distinguish using swaps for hedging from swap dealing).

    ---------------------------------------------------------------------------

    Specifically, the CFTC is adopting as an interim final rule CFTC

    Regulation Sec. 1.3(ggg)(6)(iii), which provides that the

    determination of whether a person is a swap dealer will not consider a

    swap that the person enters into, if:

    (i) The person enters into the swap for the purpose of offsetting

    or mitigating the person's price risks that arise from the potential

    change in the value of one or several (a) assets that the person owns,

    produces, manufactures, processes, or merchandises or anticipates

    owning, producing, manufacturing, processing, or merchandising; (b)

    liabilities that the person owns or anticipates incurring; or (c)

    services that the person provides, purchases, or anticipates providing

    or purchasing;

    (ii) the swap represents a substitute for transactions made or to

    be made or positions taken or to be taken by the person at a later time

    in a physical marketing channel;

    (iii) the swap is economically appropriate to the reduction of the

    person's risks in the conduct and management of a commercial

    enterprise;

    (iv) the swap is entered into in accordance with sound commercial

    practices; and

    (v) the person does not enter into the swap in connection with

    activity structured to evade designation as a swap dealer.\215\

    ---------------------------------------------------------------------------

    \215\ See CFTC Regulation Sec. 1.3(ggg)(6)(iii). All five

    requirements set forth in the regulation must be met with respect to

    the swap, in order for the swap to be excluded from the swap dealer

    determination by the regulation.

    ---------------------------------------------------------------------------

    Thus, although the CFTC is not incorporating the bona fide hedging

    provisions of the CFTC's position limits rule here, the exclusion from

    the swap dealer analysis draws upon language in the CFTC's definition

    of bona fide hedging.\216\ For example, the exclusion expressly

    includes swaps hedging price risks arising from the potential change in

    value of existing or anticipated assets, liabilities, or services, if

    the hedger has an exposure to physical price risk. And, as in the bona

    fide hedging rule, the exclusion utilizes the word ``several'' to

    reflect that there is no requirement that swaps hedge risk on a one-to-

    one transactional basis in order to be excluded, but rather they may

    hedge on a portfolio basis.\217\ For these reasons, swaps that qualify

    as enumerated hedging transactions and positions are examples of the

    types of physical commodity swaps that are excluded from the swap

    dealer analysis if the rule's requirements are met.\218\

    ---------------------------------------------------------------------------

    \216\ See CFTC Regulation Sec. 151.5(a)(1). The definition of

    bona fide hedging in CFTC Regulation Sec. 1.3(z), which applies for

    excluded commodities, is not relevant here, because it does not

    contain the requirement that the swap represents a substitute for a

    transaction made or to be made or a position taken or to be taken in

    a physical marketing channel, as required by CFTC Regulation Sec.

    1.3(ggg)(6)(iii)(B). We believe that this requirement is an

    important aspect of how principles from the bona fide hedging

    definition are useful in identifying swaps that are entered into for

    the purpose of hedging as opposed to other purposes.

    \217\ See CFTC, Position Limits for Futures and Swaps; Final

    Rule, 76 FR 71626, 71649 (Nov. 18, 2011).

    \218\ The swaps that qualify as enumerated hedging transactions

    and positions are those listed in CFTC Regulation Sec. 151.5(a)(2)

    and appendix B to part 151. These examples are illustrative of the

    types of ``assets,'' ``liabilities,'' and ``services'' contemplated

    in CFTC Regulation Sec. 1.3(ggg)(6)(iii), because the price risk

    arising from changes in their value could be offset or mitigated

    with a swap that represents a substitute for transactions made or to

    be made or positions taken or to be taken by the person at a later

    time in a physical marketing channel. To be clear, notwithstanding

    that a swap does not fit precisely within such examples, it may

    still satisfy CFTC Regulation Sec. 1.3(ggg)(6)(iii).

    Regarding commenters' queries about dynamic hedging, which one

    commenter described as the ability to modify the hedging structure

    related to physical assets or positions when relevant pricing

    relationships applicable to that asset change (see joint letter from

    WGCEF and CMC), we note that qualification as bona fide hedging has

    never been understood to require that hedges, once entered into,

    must remain static. We expect that entites would move to update

    their hedges periodically when pricing relationships or other market

    factors applicable to the hedge change.

    ---------------------------------------------------------------------------

    This provision in the final rule is consistent with our overall

    interpretive approach to the definition of the term ``swap dealer.''

    The interpretations of the statutory dealer definitions by both

    Commissions focus on a person's activities in relation to its

    counterparties and other market participants.\219\ As noted above, for

    example, one indicator that a person enters into swaps as part of ``a

    regular business'' is that the person does so to satisfy the business

    or risk management needs of the counterparty. This aspect of the swap

    dealer analysis turns on the accommodation of a counterparty's needs or

    demands. If a person enters into swaps for the purpose of hedging a

    physical position as defined in CFTC Regulation Sec. 1.3(ggg)(6)(iii),

    by contrast, then the swap can be identified as not having been entered

    into for the purpose of accommodating the counterparty's needs or

    demands.\220\ Also, a person's activity of seeking out swap

    counterparties in order to hedge a physical position as defined in the

    rule generally would not warrant regulations to promote market

    stability and transparency or to serve the other purposes of dealer

    regulation.\221\

    ---------------------------------------------------------------------------

    \219\ See parts II.A.4.e and II.A.5.a, infra. For example, the

    conclusion that a person's relationship with its counterparties can

    lead to associated obligations is consistent with the ``shingle

    theory,'' which implies a duty of fair dealing when a person hangs

    out its shingle to do business. See note 260, infra.

    \220\ In this way, the exclusion from the swap dealer analysis

    of swaps hedging physical positions as defined in CFTC Regulation

    Sec. 1.3(ggg)(6)(iii) is similar to the exclusions, discussed

    below, of swaps between affiliates and swaps between a cooperative

    and its members. See CFTC Regulation Sec. 1.3(ggg)(6)(i)(ii); see

    also part II.C, infra. However, to the extent a person engages in

    dealing activities involving swaps, the presence of offsetting

    positions that hedge those dealing activities would not excuse the

    requirement that the person register as a swap dealer.

    \221\ Thus, the CFTC's interpretation of the swap dealer

    definition in this regard draws upon principles in the dealer-trader

    distinction. See part II.A.4.a. Additional authority for CFTC

    Regulation Sec. 1.3(ggg)(6)(iii) is provided by subparagraph (B) of

    the swap dealer definition. This subparagraph provides that a person

    ``may be designated as a swap dealer for a single type or single

    class or category of swap or activities and considered not to be a

    swap dealer for other types, classes, or categories of swaps or

    activities.'' CEA Section 1a(49)(B), 7 U.S.C. 1a(49)(B). It thereby

    authorizes a review of a person's various activities with respect to

    swaps, and a determination that some of the person's activities are

    covered by a designation as a swap dealer, while other of the

    person's activities are not. Thus, a person who enters into some

    swaps for hedging physical positions as defined in CFTC Regulation

    Sec. 1.3(ggg)(6)(iii), and also enters into other swaps in

    connection with activities covered by the swap dealer definition,

    could be designated as a swap dealer only for the latter activities.

    ---------------------------------------------------------------------------

    At the same time, however, there may be circumstances where a

    person's activity of entering into swaps is encompassed by the

    statutory definition of the term ``swap dealer,'' notwithstanding that

    the swaps have the effect of hedging or mitigating the person's

    commercial risk.\222\ Although these swaps could, in theory, be

    excluded from the swap dealer analysis, we believe that a broader, per

    se exclusion for all swaps that hedge or mitigate commercial risk is

    [[Page 30613]]

    inappropriate for the swap dealer definition.

    ---------------------------------------------------------------------------

    \222\ For example, ``pay floating/receive fixed'' swaps entered

    into by a swap dealer with long exposure to the floating side of a

    market would have the effect of hedging the dealer's exposure.

    ---------------------------------------------------------------------------

    First, the hedging exclusion that we are adopting is in the nature

    of a safe harbor; i.e., it describes activity that will not be

    considered swap dealing activity. As such, the CFTC believes that it is

    appropriate that the interim final rule not be cast broadly.\223\ This

    does not mean that other types of hedging activity that do not meet the

    requirements of the interim final rule are necessarily swap dealing

    activity. Rather, such hedging activity is to be considered in light of

    all other relevant facts and circumstances to determine whether the

    person is engaging in activity (e.g., accommodating demand for swaps,

    making a market for swaps, etc.) that makes the person a swap dealer.

    ---------------------------------------------------------------------------

    \223\ While we recognize that a rule delineating the swap

    activities that do not constitute swap dealing would simplify and

    make more certain, at least in some contexts, the application of the

    swap dealer definition, there are also reasons for caution in

    incorporating a categorical exclusion for hedging.

    ---------------------------------------------------------------------------

    Second, the usefulness of an exclusion of all swaps that hedge or

    mitigate commercial risk for certain aspects of the major swap

    participant definition \224\ is not a reason to use the same exclusion

    in the swap dealer definition, since the swap dealer definition serves

    a different function. The definition of the term ``major swap

    participant,'' which applies only to persons who are not swap

    dealers,\225\ is premised on the prior identification, by the swap

    dealer definition, of persons who accommodate demand for swaps, make a

    market in swaps, or otherwise engage in swap dealing activity. The

    major swap participant definition performs the subsequent function of

    identifying persons that are not swap dealers, but hold swap positions

    that create an especially high level of risk that could significantly

    impact the U.S. financial system.\226\ Only for this subsequent

    function is it appropriate to apply the broader exclusion of swaps held

    for the purpose of hedging or mitigating commercial risk.\227\

    ---------------------------------------------------------------------------

    \224\ See part IV.C, infra.

    \225\ See CEA Sec. 1a(33)(A)(i), 7 U.S.C. 1a(33)(A)(i).

    \226\ See CEA Sec. 1a(33)(B), 7 U.S.C. 1a(33)(B).

    \227\ We do not believe that the differences between the

    exclusion in the major participant definitions for swaps held for

    the purpose of hedging or mitigating commercial risk and the

    exclusion in the swap dealer definition for certain swaps entered

    into for the purpose of hedging risks related to physical positions

    mean that the Commissions, or the CFTC in particular, have

    implemented two different definitions of hedging. In fact, neither

    of these exclusions define the term ``hedging.'' Rather, the

    differences between the two exclusions reflect differences in the

    parameters that must be satisfied in order to ensure that hedging

    swaps are appropriately excluded from the two different definitions.

    ---------------------------------------------------------------------------

    The CFTC believes that since the over-the-counter swap markets have

    operated largely without regulatory oversight and encompass swaps used

    for a wide variety of commercial purposes, no method has yet been

    developed to reliably distinguish, through a per se rule, between: (i)

    Swaps that are entered into for the purpose of hedging or mitigating

    commercial risk; and (ii) swaps that are entered into for the purpose

    of accommodating the counterparty's needs or demands or otherwise

    constitute swap dealing activity, but which also have a hedging

    consequence.\228\ In contrast, the CFTC notes that it has set forth and

    modified standards for bona fide hedging transactions and granted

    exemptions in compliance with such standards for decades.\229\ These

    historically-developed standards form the basis of the interim final

    rule excluding from the swap dealer analysis certain swaps that hedge

    the risks associated with a physical position.

    ---------------------------------------------------------------------------

    \228\ As noted in the preceding paragraph, it is not necessary

    to make this distinction for purposes of the major swap participant

    definition.

    \229\ See, e.g., 42 FR 42751 (Aug. 8, 1977). Although the latest

    formulation of the definition of bona fide hedging--CFTC Regulation

    Sec. 151.5(a)--was recently adopted, see CFTC, Position Limits for

    Futures and Swaps; Final Rule and Interim Final Rule, 76 FR 71626

    (Nov. 18, 2011), the bona fide hedging test has been in use for

    decades.

    ---------------------------------------------------------------------------

    The exclusion in CFTC Regulation Sec. 1.3(ggg)(6)(iii) depends not

    on the effect or consequences of the swap, but on whether the purpose

    for which a person enters into a swap is to hedge a physical position

    as defined in the rule. If so, then the swap is excluded from the

    dealer analysis because using swaps for that purpose is inconsistent

    with, and is not, dealing activity.\230\ On the other hand, if, at the

    time the swap is entered into, the person's purpose for entering into

    the swap is not as defined in CFTC regulation Sec. 1.3(ggg)(6)(iii),

    or if it is unclear whether the swap is for such purpose, then the fact

    that the swap hedges the person's exposure in some regard does not

    preclude consideration of that swap in the dealer analysis.\231\ In

    this latter case, all relevant facts and circumstances regarding the

    swap and the person's activity with respect to the swap would be

    relevant in the determination of whether the person is a swap

    dealer.\232\

    ---------------------------------------------------------------------------

    \230\ To be clear, the swaps a person enters into for hedging

    physical positions as defined in CFTC Regulation Sec.

    1.3(ggg)(6)(iii) are not indicative of dealing activity under any of

    the prongs of the swap dealer definition.

    \231\ In this regard, CFTC Regulation Sec. 1.3(ggg)(6)(iii) is

    different from certain of the CFTC's rules regarding bona fide

    hedging, where a person's purpose in entering into a swap may not be

    relevant.

    \232\ We believe that, in practice, the difficulty of

    distinguishing, in applying the swap dealer definition, swaps

    entered into for the purpose of hedging from other types of swaps

    will be resolvable when the facts and circumstances of a person's

    swap activities are taken into consideration in light of our

    interpretive guidance.

    ---------------------------------------------------------------------------

    We believe that, based on the CFTC's experience in applying bona

    fide hedging principles with respect to swaps hedging risks related to

    physical positions, the exclusion in CFTC Regulation Sec.

    1.3(ggg)(6)(iii) at this time is the best means of providing certainty

    to market participants regarding which swaps may be disregarded in the

    dealer analysis. However, commenters presented a range of views as to

    the exclusions from the dealer analysis that may be appropriate in this

    regard.\233\ Accordingly, the CFTC is implementing this exclusion on an

    interim rule basis and is seeking comments on all aspects of the

    interim rule, including any adjustments that may be appropriate in the

    rule or accompanying interpretive guidance.

    ---------------------------------------------------------------------------

    \233\ See, e.g., letters cited in note 141, supra.

    ---------------------------------------------------------------------------

    The CFTC also seeks comments on whether a different approach to

    swaps entered into for the purpose of hedging risk is appropriate to

    implement the statutory definition of the term ``swap dealer.''

    For example, the CFTC invites commenters to address whether any

    exclusion of hedging swaps from the swap dealer analysis is

    appropriate, and if so, how swaps that are entered into for purposes of

    hedging may be identified and distinguished from other swaps.

    Commenters are encouraged to address whether it is relevant to

    distinguish swaps entered into for purposes of hedging from swaps that

    have a consequential result of hedging, and if so, how such swaps may

    be distinguished. Also, commenters may address whether the exclusion

    should be limited to swaps hedging risks related to physical positions

    or extended to encompass swaps hedging financial risks or other types

    of risks.

    Commenters should address whether the exclusion in CFTC Regulation

    Sec. 1.3(ggg)(6)(iii) should be consistent with the exclusion in CFTC

    Regulation Sec. 1.3(kkk). If so, why, and if not, why not? If the two

    exclusions should be consistent, does consistency require that that

    exclusions be identical, or would there be variations in application of

    the two exclusions? Are there market participants whose swap positions

    would be classified as held for the purpose of hedging or mitigating

    commercial risk under CFTC Regulation

    [[Page 30614]]

    Sec. 1.3(kkk) but would not qualify for the exclusion under CFTC

    Regulation Sec. 1.3(ggg)(6)(iii)? If so, specifically identify the

    types of market participants and swaps. If the CFTC were to apply in

    the swap dealer definition the exclusion in CFTC Regulation Sec.

    1.3(kkk) in lieu of the exclusion in CFTC Regulation Sec.

    1.3(ggg)(6)(iii), would there be negative market impacts? If so, what

    are they? Would there be positive market impacts? If so, what are they?

    In particular, what type(s) of swaps that ``hedge or mitigate

    commercial risk,'' but that are not excluded under the interim rule,

    may constitute dealing activity in light of the rules and interpretive

    guidance regarding the swap dealer definition set forth in this

    Adopting Release?

    Comments regarding the costs and benefits related to the interim

    final rule and any alternative approaches, including in particular the

    quantification of such costs and benefits, are also invited.

    Commenters are encouraged, to the extent feasible, to be

    comprehensive and detailed in providing their approach and rationale.

    The comment period for the interim final rule will close July 23, 2012.

    f. Swaps Entered Into by Persons Registered as Floor Traders

    Commenters discussed whether the swap dealer definition encompasses

    the activity of entering into swaps on or subject to the rules of a DCM

    or SEF, and submitted for clearing to a derivatives clearing

    organization (``DCO''), particularly when firms engage in that activity

    using only proprietary funds.\234\ Because Title VII of the Dodd-Frank

    Act amended the definition of floor trader specifically to encompass

    activities involving swaps,\235\ the CFTC believes that it would lead

    to potentially duplicative regulation if floor traders engaging in

    swaps in their capacity as floor traders were also required to register

    as swap dealers. Accordingly, the CFTC believes that it is appropriate

    not to consider such swaps when determining whether a person acting as

    a floor trader, as defined under CEA section 1a(23),\236\ and

    registered with the CFTC under CFTC Regulation Sec. 3.11, is a swap

    dealer if the floor trader meets certain conditions. Specifically, the

    final rule provides that, in determining whether a person is a swap

    dealer, each swap that the person enters into in its capacity as a

    floor trader as defined by CEA section 1a(23) or on a SEF shall not be

    considered for the purpose of determining whether the person is a swap

    dealer, provided that the person:

    ---------------------------------------------------------------------------

    \234\ See letter from Trading Coalition. One commenter

    specifically discussed floor traders and floor brokers and the

    regulatory regime that should apply to them following implementation

    of the Dodd Frank Act. See letter from Christopher K. Hehmeyer.

    We note that other commenters suggested that all swaps cleared

    on an exchange should be excluded from the dealer definitions. See

    letters cited in note 138, supra. However, the discussion here is

    limited to persons who are registered as floor traders and meet

    other conditions. Also, the final rule provision discussed here does

    not exclude floor traders from the definition of the term ``swap

    dealer;'' rather, it provides that if the stated conditions are met,

    certain swaps entered into by floor traders are excluded from the

    swap dealer analysis.

    \235\ See section 721(a)(11) of the Dodd-Frank Act (amending the

    definition of the term ``floor trader'' in CEA section 1a(23)). The

    Exchange Act does not have an equivalent regulatory category to

    floor trader under the CEA, and thus Congress did not make a similar

    amendment to the Exchange Act.

    \236\ The definition of the term ``floor trader'' includes a

    person entering into swaps on a ``contract market.'' See CEA section

    1a(23). This exclusion also encompasses swaps that a registered

    floor trader enters into on or subject to the rules of a SEF, in

    addition to on or subject to the rules of a DCM, so long as the swap

    meets the conditions stated in the exclusion.

    ---------------------------------------------------------------------------

    (i) Is registered with the CFTC as a floor trader pursuant to CFTC

    Regulation Sec. 3.11;

    (ii) enters into swaps solely with proprietary funds for that

    trader's own account on or subject to the rules of a DCM or SEF, and

    submits each such swap for clearing to a DCO;

    (iii) is not an affiliated person of a registered swap dealer;

    (iv) does not directly, or through an affiliated person, negotiate

    the terms of swap agreements, other than price and quantity or to

    participate in a request for quote process subject to the rules of a

    DCM or SEF;

    (v) does not directly or through an affiliated person offer or

    provide swap clearing services to third parties;

    (vi) does not directly or through an affiliated person enter into

    swaps that would qualify as hedging physical positions pursuant to CFTC

    Regulation Sec. 1.3(ggg)(6)(iii) or hedging or mitigating commercial

    risk pursuant to CFTC Regulation Sec. 1.3(kkk), with the exception of

    swaps that are executed opposite a counterparty for which the

    transaction would qualify as a bona fide hedging transaction;

    (vii) does not participate in any market making program offered by

    a DCM or SEF; and

    (viii) complies with the record keeping and risk management

    requirements of CFTC Regulation Sec. Sec. 23.201, 23.202, 23.203, and

    23.600 with respect to each such swap as if it were a swap dealer.\237\

    ---------------------------------------------------------------------------

    \237\ See CFTC Regulation Sec. 1.3(ggg)(6)(iv).

    ---------------------------------------------------------------------------

    This rule permits floor traders who might otherwise be required to

    register as a swap dealer to be registered solely as floor traders with

    the CFTC. Given the limitations on the scope of the rule, the

    requirements for floor traders using the relief to comply with

    recordkeeping and risk management rules applicable to swap dealers as a

    condition of the relief, and the fact that swaps subject to the rule

    are traded on a DCM or SEF and cleared through a DCO, the CFTC believes

    it is not necessary to have floor traders subject to this rule register

    as both floor traders and swap dealers as a result of swaps activities

    covered by the rule.\238\

    ---------------------------------------------------------------------------

    \238\ The Commissions note the rule applies only to CFTC-

    registered floor traders engaging in swaps on DCMs or SEFs and

    cleared through DCOs. As noted above, the SEC does not have a

    regulatory category under the Exchange Act equivalent to floor

    trader under the CEA and none of these provisions apply in the

    context of security-based swap dealers or any entity regulated under

    the Exchange Act. Any person engaging in security-based swap

    transactions, whether or not these activities are similar to those

    engaged in by floor traders, will need to independently consider

    whether they need to register as security-based swap dealers as a

    result of their activities.

    ---------------------------------------------------------------------------

    g. Additional Interpretive Issues Relating to the ``Swap Dealer''

    Definition

    As noted above, the Commissions, in consideration of comments

    received, are making certain modifications to the interpretive guidance

    concerning the definition of the term ``swap dealer'' set out in the

    Proposing Release. However, the Commissions are retaining certain

    elements of their proposed interpretation of the term ``swap dealer,''

    as discussed below.

    First, with respect to the comments asserting that the proposed

    interpretive approach is overly broad,\239\ we note that the statute

    provides that the term ``swap dealer'' means ``any person'' who engages

    in the activities described in any of the four prongs of the

    definition, subject to the exceptions and qualifications set out in the

    statute. In view of this statutory text, these comments effectively

    assert that the statute should be interpreted to include preconditions

    to swap dealer status that are not set forth in the statute. For

    example, the assertion that the swap dealer definition must be limited

    to persons who enter into swaps on both sides of the market would

    impose a requirement that does not exist in the statute. Similarly, the

    comments to the effect that swap dealers are only those persons who

    seek to profit by intermediating between swap market participants adds

    a requirement not set forth in the statute.

    ---------------------------------------------------------------------------

    \239\ See letters cited at notes 83 to 84, supra.

    ---------------------------------------------------------------------------

    We believe, though, that the activities that cause a person to be

    covered by the

    [[Page 30615]]

    swap dealer definition should be addressed in the context of the four

    prongs of the statutory definition. That is, the relevant question is

    whether a person engages in any of the types of activities enumerated

    in the statute, and not whether the person meets any additional,

    supposedly implicit preconditions to swap dealer status.

    Second, the Commissions continue to believe, as stated in the

    Proposing Release, that accommodating demand and facilitating interest

    are appropriately used as factors in identifying swap dealers. As noted

    by commenters, however, the mere fact that a person entering into a

    particular swap has the effect of ``accommodating demand'' or

    ``facilitating interest'' in swaps does not conclusively establish that

    the person is a swap dealer. Instead, the person's overall activities

    in the swap market (or particular sector of the swap market if the

    person is active in a variety of sectors) should be compared against

    these factors. If, in the context of its overall swap activities, a

    person fulfills a function of accommodating demand or facilitating

    interest in swaps for other parties, then these factors would be

    significant in the analysis and the person is likely to be a swap

    dealer.\240\

    ---------------------------------------------------------------------------

    \240\ The language of the four statutory tests for swap dealer

    status (which refer to a person who holds itself out as a dealer, is

    commonly known as a dealer, makes a market in swaps or regularly

    enters into swaps with counterparties) contemplate that a dealer is

    a person who, through its swap activities, functions to create legal

    relationships that transfer risk between independent persons. See

    CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A).

    See also Proposing Release, 75 FR at 80177 (describing swap

    dealers as those persons whose function is to serve as the points of

    connection in the swap markets); letter from COPE I at 4 (``Simply

    stated, dealers are in the regular business of being a point of

    connection to the market for others that need access to the market

    to hedge risk.''): Roundtable Transcript at 21 (remarks of Richard

    Ostrander, Morgan Stanley; ``a dealer is someone who is out there

    willing to enter into trades'').

    ---------------------------------------------------------------------------

    Third, as discussed above, we have adopted some of the objective

    criteria suggested by commenters with respect to the indicia of holding

    oneself out as a dealer or being commonly known as a dealer, market

    making, and the ``regular business'' prongs of the swap dealer

    definition.\241\ For instance, allocating staff and technological

    resources to swap activity, deriving revenue and profit from swap

    activity, or responding to customer-initiated orders for swaps can all

    be indicative of having ``a regular business'' of entering into swaps

    and, therefore, indicative of being a swap dealer. In addition,

    activities such as providing advice about swaps or offering oneself as

    a point of connection to other parties needing access to the swap

    market are indicative of a person holding itself out as a swap dealer,

    if the person also enters into swaps in conjunction with such

    activities.

    ---------------------------------------------------------------------------

    \241\ See part II.B.2.d.iii, supra.

    ---------------------------------------------------------------------------

    The guidance we have provided about these indicia is responsive to

    concerns expressed by commenters about the application of the swap

    dealer definition to energy markets. As described above, some

    commenters stated that in energy markets, unlike in some other markets,

    end-users often enter into swaps directly with each other, on both

    sides of the market, without the involvement of a separate category of

    businesses serving as intermediaries.\242\ As a result, according to

    these commenters, energy swap market participants often engage in some

    of the activities that are indicative of swap dealer status. Some of

    these commenters contended that our activity-based interpretation of

    the swap dealer definition could therefore result in the inappropriate

    inclusion of energy market participants in the coverage of the

    definition of the term ``swap dealer.'' \243\

    ---------------------------------------------------------------------------

    \242\ See parts II.A.2.f.ii and iii, supra.

    \243\ See letters cited in note 117, supra. Comments expressing

    concern that the definition of the term ``swap dealer'' could

    include physical commodities businesses also were presented to

    Congress during consideration of legislation leading to passage of

    the Dodd-Frank Act. See Proposed Legislation by the U.S. Department

    of the Treasury Regarding the Regulation of Over-The-Counter

    Derivatives Markets: Hearing Before the H. Comm. On Agriculture,

    111th Cong. 103 (2009) (submitted report on behalf of the Working

    Group of Commercial Energy Firms). However, as noted above, there is

    no exclusion in the statutory definition for such businesses.

    ---------------------------------------------------------------------------

    We believe that the language of the statutory ``swap dealer''

    definition supports our activity-based interpretation and does not

    support categorical exclusions of particular types of persons from the

    ``swap dealer'' definition based on the general nature of their

    businesses. Further evidence that such a categorical exclusion is

    unwarranted is provided by the fact that a number of energy market

    participants--BP Plc., Cargill, Incorporated, Centrica Energy Limited,

    ConocoPhillips, EDF Trading Limited, GASELYS, Hess Energy Trading

    Company, LLC, Hydro-Quebec, Koch Supply & Trading, LP, RWE Supply &

    Trading GmbH, Shell Energy North America (US), L.P., STASCO, Totsa

    Total Oil Trading S.A., and Vattenfall Energy Trading Netherlands

    N.V.--have voluntarily joined ISDA as primary dealers.\244\ As

    previously noted, any business organization that ``deals in derivatives

    shall be eligible for election to membership in the Association as a

    primary member, provided that no person or entity shall be eligible for

    membership as a Primary Member if such person or entity participates in

    derivatives transactions solely for the purpose of risk hedging or

    asset or liability management.'' \245\ Hence, a categorical exclusion

    from the ``swap dealer'' definition based on any particular type of

    business or general market activity also would be inconsistent with

    current industry structure and practice.

    ---------------------------------------------------------------------------

    \244\ The list of ISDA Primary Members is available at http://www.isda.org/membership/isdamemberslist.pdf.

    \245\ See note 188, supra.

    ---------------------------------------------------------------------------

    At the same time, however, the fact that a person engages in some

    swap activities that are indicative of swap dealer status does not, by

    itself, mean that the person is covered by the definition of the term

    ``swap dealer.'' The ``not as part of a regular business'' exception

    and our guidance about its meaning address the issue of swap market

    participants that engage to some extent in the activities

    characteristic of swap dealers. The guidance we have provided here

    therefore provides the appropriate approach to addressing these issues

    in energy markets as elsewhere.

    Although several commenters attempted to articulate bright-line

    tests that would differentiate swap dealers from other swap market

    participants, the suggested bright-line tests generally could not be

    applied across the board to all types of swap market activity. For

    example, some commenters suggested that swap dealers can be identified

    as those who profit from entering into swaps on both sides of the

    market (and under the interpretive approach set forth in this Adopting

    Release, such activity may be an indicator of swap dealing).\246\ But

    other commenters said that, in certain circumstances, entering into

    swaps on both sides of the market is not necessarily indicative of swap

    dealing.\247\

    ---------------------------------------------------------------------------

    \246\ See letters cited in note 84, supra.

    \247\ See letters cited in note 86, supra. As noted above in the

    discussion of market making, a swap dealer may in some circumstances

    enter into swaps on only one side of the market.

    ---------------------------------------------------------------------------

    The ways in which participants throughout the market use swaps are

    simply too diverse for swap dealer status to be resolved with a single,

    one-factor test. This is reflected in the statutory definition of the

    term ``swap dealer'' itself. Focused as it is on types of activities,

    with four prongs set forth in the alternative to cover different types

    of swap dealing activity, the statutory swap dealer definition is not

    susceptible to the bright-line test that

    [[Page 30616]]

    some commenters seek. For these reasons, we continue to believe that it

    is appropriate to apply the multi-factor interpretive approach set

    forth in this Adopting Release.

    In closing, we emphasize that the purpose of in this part IV.A.4 is

    to provide guidance as to how the rules further defining the term

    ``swap dealer'' will be applied in particular, complex situations where

    a person's status as a swap dealer may be uncertain. Even though

    bright-line tests and categorical exclusions are inappropriate, we

    recognize that the large majority of market participants use swaps for

    normal course hedging, financial, investment or trading purposes and

    are not swap dealers.

    5. Final Rules and Interpretation--Definition of ``Security-Based Swap

    Dealer''

    a. General Reliance on the Dealer-Trader Distinction

    As discussed above, we are adopting a rule under the Exchange Act

    that defines ``security-based swap dealer'' in terms of the four

    statutory tests and the exclusion for security-based swap activities

    that are not as part of a ``regular business.'' \248\ Also, we believe

    that the dealer-trader distinction \249\--which already forms a basis

    for identifying which persons fall within the longstanding Exchange Act

    definition of ``dealer''--in general provides an appropriate framework

    for interpreting the meaning of ``security-based swap dealer.'' \250\

    While there are differences in the structure of those two statutory

    definitions,\251\ we believe that their parallels--particularly both

    definitions' exclusions for activities that are ``not part of a regular

    business''--warrant analogous interpretive approaches for

    distinguishing dealers from non-dealers.

    ---------------------------------------------------------------------------

    \248\ See Exchange Act rule 3a71-1(a), (b).

    \249\ See note 31, supra.

    \250\ The principles embedded within the ``dealer-trader

    distinction'' are not solely useful for distinguishing persons who

    constitute dealers from active ``traders,'' but also are applicable

    to distinguishing dealers from non-dealers such as hedgers or

    investors. The ``dealer-trader'' nomenclature has been used for

    decades. See Loss, Securities Regulation 722 (1st ed. 1951) (``One

    aspect of the `business' concept is the matter of drawing the line

    between a `dealer' and a trader--an ordinary investor who buys and

    sells for his own account with some frequency.'').

    \251\ For example, while the ``dealer'' definition encompasses

    certain persons in the business of ``buying and selling''

    securities, the ``security-based swap dealer'' definition does not

    address either ``buying'' or ``selling.'' As we noted in the

    Proposing Release, we do not believe that the lack of those terms in

    the ``security-based swap dealer'' definition leads to material

    interpretive distinctions, as the Dodd-Frank Act amended the

    Exchange Act definitions of ``buy'' and ``purchase,'' and the

    Exchange Act definitions of ``sale'' and ``sell,'' to encompass the

    execution, termination (prior to its scheduled maturity date),

    assignment, exchange or similar transfer or conveyance of, or

    extinguishing of rights or obligations under, a security-based swap.

    See Proposing Release, 75 FR at 80178 n.26 (citing Dodd-Frank Act

    sections 761(a)(3), (4), which amend Exchange Act sections 3(a)(13),

    (14)).

    At the same time, we note that the ``dealer'' definition

    requires the conjunctive ``buying and selling''--which connotes a

    degree of offsetting two-sided activity. In contrast, the

    ``security-based swap dealer'' definition (particularly the

    ``regularly enters into security-based swaps'' language of the

    definition's third test) lacks that conjunctive terminology.

    ---------------------------------------------------------------------------

    As discussed above,\252\ the Commissions note that interpretations

    of the applicability of the dealer-trader distinction to the ``swap

    dealer'' definition under the CEA do not affect existing, or future,

    interpretations of the dealer-trader distinction under the Exchange

    Act--both with regard to the ``security-based swap dealer'' definition,

    and with regard to the ``dealer'' definition.

    ---------------------------------------------------------------------------

    \252\ See note 171, supra.

    ---------------------------------------------------------------------------

    In interpreting the security-based swap dealer definition in terms

    of the dealer-trader distinction, the Commissions have been mindful

    that some commenters expressed the view that we instead should rely on

    other interpretive factors that were identified in the Proposing

    Release (e.g., accommodating demand). We believe, nonetheless, that the

    dealer-trader distinction forms the basis for a framework that

    appropriately distinguishes between persons who should be regulated as

    security-based swap dealers and those who should not. We also believe

    that the distinction affords an appropriate degree of flexibility to

    the analysis, and that it would not be appropriate to seek to codify

    the distinction.

    At the same time, the Commissions recognize that the dealer-trader

    distinction needs to be adapted to apply to security-based swap

    activities in light of the special characteristics of security-based

    swaps and the differences between the ``dealer'' and ``security-based

    swap dealer'' definitions. Relevant differences include:

    Level of activity--Security-based swap markets are marked

    by less activity than markets involving certain other types of

    securities (while recognizing that some debt and equity securities are

    not actively traded). This suggests that in the security-based swap

    context concepts of ``regularity'' should account for the level of

    activity in the market.

    No separate issuer--Each counterparty to a security-based

    swap in essence is the ``issuer'' of that instrument; in contrast,

    dealers in cash market securities generally transact in securities

    issued by another party. This distinction suggests that the concept of

    turnover of ``inventory'' of securities, which has been identified as a

    factor in connection with the dealer-trader distinction, is inapposite

    in the context of security-based swaps. Moreover, this distinction--

    along with the fact that the ``security-based swap dealer'' definition

    lacks the conjunctive ``buying and selling'' language of the ``dealer''

    definition \253\--suggests that concepts of two-sided markets at times

    would be less relevant for identifying ``security-based swap dealers''

    than they would be for identifying ``dealers.'' \254\

    ---------------------------------------------------------------------------

    \253\ See note 251, supra.

    \254\ The analysis also should account for the fact that a party

    to a security-based swap can use other derivatives or cash market

    instruments to hedge the risks associated with the security-based

    swap position, meaning that two-way trading is not necessary to

    maintain a flat risk book.

    ---------------------------------------------------------------------------

    Predominance of over-the-counter and non-standardized

    instruments--Security-based swaps thus far are not significantly traded

    on exchanges or other trading systems, in contrast to some cash market

    securities (while recognizing that many cash market securities also are

    not significantly traded on those systems).\255\ These attributes--

    along with the lack of ``buying and selling'' language in the security-

    based swap dealer definition, as noted above--suggest that concepts of

    what it means to make a market need to be construed flexibly in the

    context of the security-based swap market.\256\

    ---------------------------------------------------------------------------

    \255\ Even though we expect trading of security-based swaps on

    security-based swap execution facilities or exchanges following the

    implementation of Title VII, we expect there to remain a significant

    amount of over-the-counter activity involving security-based swaps.

    \256\ For example, the definition of ``market maker'' in

    Exchange Act section 3(a)(38)--which is applicable for purposes of

    the Exchange Act ``unless the context otherwise requires'' (see

    Exchange Act section 3(a))--defines the term ``market maker'' to

    mean ``any specialist permitted to act as a dealer, any dealer

    acting in the capacity of block positioner, and any dealer who, with

    respect to a security, holds himself out (by entering quotations in

    an inter-dealer communications system or otherwise) as being willing

    to buy and sell such security for his own account on a regular or

    continuous basis.'' That definition is useful in the context of

    systems in which standardized securities are regularly or

    continuously bought and sold, but would not be apposite in the

    context of non-standardized securities or securities that are not

    regularly or continuously transacted.

    ---------------------------------------------------------------------------

    Mutuality of obligations and significance to ``customer''

    relationship--In contrast to a secondary market transaction involving

    equity or debt securities, in which the completion of a purchase or

    sale transaction can be expected to terminate the mutual obligations of

    the parties to the

    [[Page 30617]]

    transaction, the parties to a security-based swap often will have an

    ongoing obligation to exchange cash flows over the life of the

    agreement. In light of this attribute, some market participants have

    expressed the view that they have ``counterparties'' rather than

    ``customers'' in the context of their swap activities.

    It also is necessary to use the dealer-trader distinction to

    interpret the security-based swap dealer definition so that the

    statutory provisions that will govern security-based swap dealers are

    applied in an effective and logical way. Those statutory provisions

    added by the Dodd-Frank Act advance financial responsibility (e.g., the

    ability to satisfy obligations, and the maintenance of counterparties'

    funds and assets) associated with security-based swap dealers'

    activities,\257\ other counterparty protections,\258\ and the promotion

    of market efficiency and transparency.\259\ As a whole, the relevant

    statutory provisions suggest that we should apply the dealer-trader

    distinction to interpret the security-based swap dealer definition in a

    way that identifies those persons for which regulation is warranted

    either: (i) Due to the nature of their interactions with

    counterparties; \260\ or (ii) to promote market stability and

    transparency, in light of the role those persons occupy within the

    security-based swap markets.\261\

    ---------------------------------------------------------------------------

    \257\ E.g., capital and margin requirements (Exchange Act

    section 15F(e)), and requirements for segregation of collateral

    (Exchange Act section 3E).

    \258\ E.g., requirements with respect to business conduct when

    transacting with special entities (Exchange Act sections 15F(h)(2),

    (h)(4), (h)(5)); disclosure requirements (Exchange Act section

    15F(h)(3)(B)); requirements for fair and balanced communications

    (Exchange Act section 15F(h)(3)(C)); other requirements related to

    the public interest and investor protection (Exchange Act section

    15F(h)(3)(D)); and conflict of interest provisions (Exchange Act

    section 15F(j)(5)).

    \259\ E.g., reporting and recordkeeping requirements (Exchange

    Act section 15F(f)); daily trading records requirements (Exchange

    Act section 15F(g)); regulatory standards related to the

    confirmation, processing, netting, documentation and valuation of

    security-based swaps (Exchange Act section 15F(i)); position limit

    monitoring requirements (Exchange Act section 15F(j)(1)); risk

    management procedure requirements (Exchange Act section 15F(j)(2));

    and requirements related to the disclosure of information to

    regulators (Exchange Act section 15F(j)(3)).

    \260\ The conclusion that a person's relationship with its

    counterparties can lead to associated obligations is consistent with

    the ``shingle theory,'' which implies a duty of fair dealing when a

    person hangs out its shingle to do business. See Securities and

    Exchange Commission, Report of the Special Study of Securities

    Market Part I at 238 (1963) (``An obligation of fair dealing, based

    upon the general antifraud provisions of the Federal securities

    laws, rests upon the theory that even a dealer at arm's length

    impliedly represents when he hangs out his shingle that he will deal

    fairly with the public.''; footnote omitted); Weiss, Registration

    and Regulation of Brokers and Dealers 171 (1965) (``the solicitation

    and acceptance by a broker-dealer of orders from customers and the

    confirmation of transactions do constitute a representation by the

    broker-dealer that he will deal fairly with his customers and that

    such transactions will be handled promptly in the usual manner, in

    accordance with trade custom'').

    \261\ The importance of regulating dealers due to the centrality

    of their market role was illustrated by the Government Securities

    Act of 1986. When Congress provided for the regulation of government

    securities dealers, Congress specifically cited the lack of

    regulation as contributing to the failures of several unregulated

    government securities dealers. See S. Rep. No. 99-426 (1986), as

    reprinted in 1986 U.S.C.C.A.N. 5395, 5400-04. The resulting statute

    provided for a definition of ``government securities dealer'' that

    in relevant part is parallel to the definitions of ``dealer'' and

    ``security-based swap dealer,'' particularly with regard to sharing

    an exclusion for activities that are not part of a ``regular

    business.'' See Exchange Act section 3(a)(44).

    ---------------------------------------------------------------------------

    b. Principles for Applying the Dealer-Trader Distinction to Security-

    Based Swap Activity

    In light of the statutory security-based swap dealer definition,

    statutory provisions applicable to security-based swap dealers and

    market characteristics addressed above, the Commissions believe that

    the factors set forth below are relevant for identifying security-based

    swap dealers and for distinguishing those dealers from other market

    participants. This guidance seeks to address commenter requests that we

    further clarify the scope of the security-based swap dealer definition,

    and the Commissions believe that these factors provide appropriate

    guidance without being inflexible or allowing the opportunity for

    evasion that may accompany a bright-line test. At the same time, the

    determination of whether a person is acting as a security-based swap

    dealer ultimately depends on the relevant facts and circumstances. In

    light of the overall context in which a person's activity occurs, the

    absence of one or more of these factors does not necessitate the

    conclusion that a person is not a security-based swap dealer.\262\

    ---------------------------------------------------------------------------

    \262\ Similarly, depending on the relevant facts and

    circumstances, the presence of certain of the illustrative

    activities described here does not necessitate the conclusion that

    the entity is a dealer.

    ---------------------------------------------------------------------------

    Providing liquidity to market professionals or other

    persons in connection with security-based swaps. A market participant

    might manifest this indication of dealer activity by accommodating

    demand or facilitating interest expressed by other market

    participants,\263\ holding itself out as willing to enter into

    security-based swaps, being known in the industry as being available to

    accommodate demand for security-based swaps, or maintaining a sales

    force in connection with security-based swap activities.\264\

    ---------------------------------------------------------------------------

    \263\ This is to be distinguished from an entity entering into

    security-based swaps for other business purposes, such as to gain

    economic exposure to a particular market.

    \264\ A sales force, however, is not a prerequisite to a person

    being a security-based swap dealer. For example, a person that

    enters into security-based swaps in a dealing capacity can fall

    within the dealer definition even if it uses an affiliated entity to

    market and/or negotiate those security-based swaps (e.g., the person

    is a booking entity). Depending on the applicable facts and

    circumstances, the affiliate that performs the marketing and/or

    negotiation functions may fall within the Exchange Act's definition

    of ``broker'' (which was not revised by Title VII). See Exchange Act

    section 3(a)(4)(A).

    ---------------------------------------------------------------------------

    Seeking to profit by providing liquidity in connection

    with security-based swaps. A market participant may manifest this

    indication of security-based swap dealer activity--which is consistent

    with the definition's ``regular business'' requirement--by seeking

    compensation in connection with providing liquidity involving security-

    based swaps (e.g., by seeking a spread, fees or other compensation not

    attributable to changes in the value of the security-based swap).\265\

    The Commissions do not believe that this necessarily requires that a

    person be available to take either side of the market at any time, or

    that a person continuously engage in this type of activity, to be a

    security-based swap dealer. Although one commenter expressed the view

    that the security-based swap dealer definition requires that a person

    be consistently available to take either side of the market,\266\ in

    our view such an approach would be underinclusive.\267\

    ---------------------------------------------------------------------------

    \265\ Indicia of this objective may include, but would not be

    limited to, maintaining separate profit/loss statements in

    connection with this type of activity, and/or devoting staff and

    resources to this type of activity.

    In this regard, we believe that the issue of whether a person

    tends to take the prices offered in the market, rather than helping

    to set those prices (such as by providing quotes, placing limit

    orders, or otherwise accommodating demand), can be relevant as a

    factor for distinguishing security-based swap dealers from non-

    dealers. At the same time, we are mindful that a dealer may also

    accept the market price as part of its dealer activity (such as when

    a person enters into a security-based swap to offset the risk it

    assumes in connection with its security-based swap dealing

    activity); as a result, the fact that a person regularly takes the

    market price as part of its security-based swap transactions does

    not foreclose the possibility that the person may be a security-

    based swap dealer.

    \266\ See letter from ISDA I.

    \267\ It is possible for a dealer to be compensated for

    providing liquidity by entering into sequential offsetting

    positions, or by hedging the security-based swap position by using a

    different type of security-based swap, a swap or some other

    financial instrument. Accordingly, a rule of decision that permitted

    a person to avoid dealer regulation by providing liquidity in

    connection with security-based swaps, and laying off the associated

    risk using a different type of security-based swap, a swap or a

    different instrument entirely, would be susceptible to abuse.

    Moreover, as noted above, the definition of ``security-based swap

    dealer'' does not contain the ``buying and selling'' language found

    in the general Exchange Act definition of ``dealer.'' Thus, while

    being regularly willing to enter into either side of the security-

    based swap market would suggest that a person is engaged in dealing

    activity, the absence of such activity should not necessarily lead

    to an inference that a person is not acting as a dealer.

    We also note that some commenters have stated that two-way

    quoting by itself should not necessarily be enough to make a person

    a dealer, and some of those commenters specifically stated that a

    person may use two-sided quotes as part of the price discovery

    process or to elicit trading interest. See, e.g., letter from MFA I.

    Here too, it is important to consider whether the activity also has

    a dealing business purpose, such as seeking to profit by providing

    liquidity. Moreover, all participants in the security-based swap

    market, whether or not security-based swap dealers, should be

    mindful of the potential application of the antifraud and anti-

    manipulation provisions of the federal securities laws to such

    activities. Section 10(b) of the Exchange Act and Exchange Act rule

    10b-5 particularly prescribe the use of any manipulative or

    fraudulent device in connection with the purchase or sale of any

    security, which includes manipulative trading. See Terrance

    Yoshikawa, Securities Exchange Act Release No. 53731 (Apr. 26,

    2006), 87 SEC Docket 2924, 2930-31 & n.19 (citing Ernst & Ernst v.

    Hochfelder, 425 U.S. 185, 199 (1976)). The SEC has characterized

    manipulation as ``the creation of deceptive value or market activity

    for a security, accomplished by an intentional interference with the

    free forces of supply and demand.'' See Swartwood, Hesse, Inc., 50

    S.E.C. 1301, 1307 (1992) (citing Hochfelder, 425 U.S. at 199;

    Schreiber v. Burlington Northern, Inc., 472 U.S. 1 (1985); Feldbaum

    v. Avon Products, Inc., 741 F.2d 234 (8th Cir. 1984)).

    ---------------------------------------------------------------------------

    [[Page 30618]]

    Providing advice in connection with security-based swaps

    or structuring security-based swaps. Advising a counterparty as to how

    to use security-based swaps to meet the counterparty's hedging goals,

    or structuring security-based swaps on behalf of a counterparty, also

    would indicate security-based swap dealing activity. It particularly is

    important that persons engaged in those activities are appropriately

    regulated so that their counterparties will receive the protections

    afforded by certain of the statutory business conduct rules (e.g.,

    special entity requirements and communication requirements) \268\

    applicable to security-based swap dealers.\269\ The Commissions

    recognize commenter concerns that end-users may also develop new types

    of security-based swaps,\270\ but also recognize that the activities of

    end-users related to the structuring of security-based swaps for

    purposes of hedging commercial risk are appreciably different than

    being in the business of structuring security-based swaps on behalf of

    a counterparty.

    ---------------------------------------------------------------------------

    \268\ The SEC has proposed rules to implement Title VII

    provisions relating to external business conduct standards for

    security-based swap dealers (as well as major security-based swap

    participants). See Exchange Act Release No. 64766 (June 29, 2011),

    76 FR 42396 (July 18, 2011).

    \269\ This factor would also reasonably take into account

    whether a preexisting relationship involving other types of

    securities or other financial instruments is present. For example,

    to the extent a person has an existing broker or dealer relationship

    with a counterparty in connection with other types of securities,

    and also enters into a security-based swap with that counterparty, a

    reasonable inference would be that the person entered into the

    security-based swap in a dealer capacity. Any other approach would

    invite abuse, as persons could seek to leverage existing

    relationships of trust while avoiding regulation as a security-based

    swap dealer.

    \270\ See letter from FSR I.

    ---------------------------------------------------------------------------

    Presence of regular clientele and actively soliciting

    clients. These dealer-trader factors would reasonably appear to be

    applicable in the security-based swap context, just as they are

    applicable in the context of other types of securities, as indicia of a

    business model that seeks to profit by providing liquidity. The

    Commissions are mindful that some industry participants have

    highlighted a distinction between ``counterparties'' and ``customers''

    in connection with swaps, and have suggested that they have no

    ``customers'' in the swap context. We do not believe such points of

    nomenclature are significant for purposes of identifying security-based

    swap dealers, however.\271\

    ---------------------------------------------------------------------------

    \271\ For purposes of the dealer-trader analysis, as it applies

    in the context of security-based swaps or any other security, we

    would not expect contractual provisions stating that the

    counterparty is not relying on the person's advice to have any

    significance.

    ---------------------------------------------------------------------------

    Use of inter-dealer brokers. As with activities involving

    other types of securities, the Commissions would expect that a person's

    use of an inter-dealer broker in connection with security-based swap

    activities to be an indication of the person's status as a dealer.

    Acting as a market maker on an organized security-based

    swap exchange or trading system. Acting in a market maker capacity on

    an organized exchange or trading system for security-based swaps would

    indicate that the person is acting as a dealer.\272\ While the

    Commissions recognize that some commenters have expressed the view that

    persons who solely enter into security-based swaps on an organized

    security-based swap exchange or trading system should not be regulated

    as security-based swap dealers,\273\ in our view such an approach would

    be contrary to the express language of the definition. This is not to

    say, of course, that the presence of an organized exchange or trading

    system is a prerequisite to being a market maker for purposes of the

    security-based swap dealer definition.\274\ Moreover, acting as a

    market maker is not a prerequisite to being a security-based swap

    dealer.\275\ On the other hand, being a member of an organized exchange

    or trading system for purposes of trading security-based swaps does not

    necessarily by itself make a person a security-based swap dealer.\276\

    ---------------------------------------------------------------------------

    \272\ Under the proposal of the SEC, the Board, the OCC and the

    FDIC to implement the provisions of section 619 of the Dodd-Frank

    Act (also known as the ``Volcker Rule''), a person who claims the

    benefit of the market maker exception to that section's prohibitions

    and restrictions on proprietary trading in connection with security-

    based swap activities would be required to register with the SEC as

    a security-based swap dealer, unless the person is exempt from

    registration or is engaged in a dealing business outside the U.S.,

    and is subject to substantive regulation in the jurisdiction where

    the business is located. See Securities Exchange Act Release No.

    65545, 76 FR 68846, 68947 (Nov. 7, 2011) (proposed implementing rule

    Sec. ------.4(b)(2)(iv)(C)).

    \273\ See, e.g., letter from Traders Coalition.

    \274\ Given the current nature of the security-based swap

    market, including the present level of activity and the present lack

    of significant trading of security-based swaps on exchanges or

    organized trading systems, we believe that it would negate the

    legislative intent to interpret the definition's use of market

    making concepts to require the same use of quotation media that are

    incorporated into the interpretation of market making concepts in

    the context of securities that are actively traded on an organized

    exchange or trading system. At the same time, we recognize that

    routine activity in the security-based swap market is not

    necessarily indicative of making a market in security-based swaps.

    For example, persons may routinely be active in the market for

    purposes of hedging, to advance their investment objectives, or to

    engage in proprietary trading.

    \275\ The definition of ``security-based swap dealer'' contains

    four alternative tests, only two of which use market making

    terminology. Moreover, the third test of the security-based swap

    dealer definition--which addresses persons who regularly enter into

    security-based swaps as an ordinary course of business for their own

    account--appears particularly inapt as a proxy for market making

    activity. Transacting with customers is not an element of this

    alternative test. A person thus may be a security-based swap dealer

    even if it transacts exclusively with other market professionals.

    Cf. OCC, ``Risk Management of Financial Derivatives'' 3-4 (1997)

    (stating that OCC has classified banks as ``Tier I'' dealers if they

    act as market makers by ``providing quotes to other dealers and

    brokers, and other market professionals''). Compare letter from ISDA

    I (taking the view that the dealer definition should be interpreted

    in the context of market-making concepts).

    \276\ The analysis of the status of members of such exchanges

    and trading systems in part may be influenced by the final Exchange

    Act rules that govern such systems, as well as the internal rules of

    such systems.

    ---------------------------------------------------------------------------

    As with the current application of the dealer-trader distinction to the

    Exchange Act ``dealer'' definition, the question of whether a person is

    acting as a security-based swap dealer ultimately will turn upon the

    relevant facts and circumstances, as informed by these criteria.

    c. Additional Interpretive Issues

    Activity by hedgers. As noted above, a number of commenters raised

    concerns that an overbroad ``security-based swap dealer'' definition

    would inappropriately encompass persons

    [[Page 30619]]

    using security-based swaps for hedging purposes.\277\ As we stated in

    the Proposing Release, however, under the dealer-trader distinction the

    Commissions would expect persons that use security-based swaps to hedge

    their business risks, absent other activity, likely would not be

    dealers.\278\ We maintain that view. In other words, to the extent that

    a person engages in security-based swap activity to hedge commercial

    risk, or otherwise to hedge risks unrelated to activities that

    constitute dealing under the dealer-trader distinction (particularly

    activities that have the business purpose of seeking to profit by

    providing liquidity in connection with security-based swaps), the

    Commissions would not expect those hedging transactions to lead a

    person to be a security-based swap dealer.\279\ Of course, to the

    extent a person engages in dealing activities involving security-based

    swaps, the presence of offsetting positions that hedge those dealing

    activities would not excuse the requirement that the person register as

    a security-based swap dealer.\280\

    ---------------------------------------------------------------------------

    \277\ See, e.g., letter from Church Alliance.

    \278\ See Proposing Release, 75 FR at 80178 n.27. The Proposing

    Release also noted that if a person's other activities satisfy the

    definition of security-based swap dealer, the person must comply

    with the applicable requirements with regard to all of its security-

    based swap activities, absent an order to the contrary. We further

    noted in the Proposing Release that we would expect end-users to use

    security-based swaps for hedging purposes less commonly than they

    use swaps for hedging purposes.

    \279\ In addition, consistent with the exclusion from the dealer

    analysis of activities involving majority-owned affiliates, see part

    II.C, infra, to the extent that a person engages in activities to

    hedge positions subject to the inter-affiliate exclusion, absent

    other activity, the Commission would not expect those hedging

    transactions to lead a person to be a security-based swap dealer.

    Conversely, security-based swap activities connected with the

    indicia of dealing discussed above (e.g., seeking to profit by

    providing liquidity in connection with security-based swaps)

    themselves would suggest security-based swap dealing activity.

    \280\ For example, if a person were to use other instruments to

    hedge the risks associated with its security-based swap dealing

    activity, that hedging would not undermine the obligation of the

    person to register as a security-based swap dealer, notwithstanding

    the fact that it could be asserted that the dealing positions happen

    to hedge those other positions.

    ---------------------------------------------------------------------------

    No predominance test. As discussed in the Proposing Release, the

    Commissions do not believe that the security-based swap dealer analysis

    should appropriately turn upon whether a person's dealing activity

    constitutes that person's sole or predominant business. The separate de

    minimis exemption, however, may have the effect of excusing from dealer

    regulation those persons whose security-based swap dealing activities

    are relatively modest.

    Presence or absence of a customer relationship. Although commenters

    have expressed the view that a person that engages in security-based

    swap activities on an organized market should not be deemed to be a

    dealer unless it engages in those activities with customers,\281\ we do

    not agree. It is true that having a customer relationship can

    illustrate a business model of seeking to profit by providing

    liquidity, and thus provide one basis for concluding that a person is

    acting as a security-based swap dealer. Nonetheless, the presence of

    market making terminology within the definition is inconsistent with

    the view that a security-based swap dealer must have ``customers.''

    Also, Title VII requirements applicable to security-based swap dealers

    address interests apart from customer protection.\282\ Accordingly, to

    the extent that a person regularly enters into security-based swaps

    with a view toward profiting by providing liquidity--rather than by

    taking directional positions--that person may be a security-based swap

    dealer regardless of whether it views itself as maintaining a

    ``customer'' relationship with its counterparties.\283\

    ---------------------------------------------------------------------------

    \281\ See letters from ISDA I and Traders Coalition.

    \282\ Particularly in light of the view expressed by some market

    participants that they only have ``counterparties'' in the swap

    markets, and not ``customers,'' any interpretation of the

    ``security-based swap dealer'' definition that is predicated on the

    existence of a customer relationship may lead to an overly narrow

    construction of the definition.

    \283\ For example, a person's activity involving entering into

    security-based swaps on a SEF may cause it to be a security-based

    swap dealer even in the absence of a customer relationship with any

    of its counterparties.

    ---------------------------------------------------------------------------

    Criteria associated with ``holding self out'' as a dealer or being

    ``commonly known in the trade'' as a security-based swap dealer. The

    Proposing Release articulated a number of activities that could satisfy

    the definition's tests for a person ``holding itself out'' as a dealer

    or being ``commonly known in the trade'' as a dealer.\284\ Several

    commenters criticized those proposed criteria, largely on the grounds

    that those criteria would inappropriately encompass end-users who seek

    to use security-based swaps for hedging purposes, or otherwise would be

    overbroad or irrelevant.\285\ The Commissions recognize the

    significance of the concerns those commenters raised, and agree that

    these activities need to be considered within the context of whether a

    person engages in those activities with the purpose of facilitating

    dealing activity. While we do not believe that any of those activities

    by themselves would necessarily indicate that a person is acting as a

    security-based swap dealer, under certain circumstances they may serve

    as an indicia of a business purpose of seeking to profit by providing

    liquidity in connection with security-based swaps.\286\

    ---------------------------------------------------------------------------

    \284\ As noted above, these were: contacting potential

    counterparties to solicit interest; developing new types of swaps or

    security-based swaps and informing potential counterparties of their

    availability and of the person's willingness to enter into the swap

    or security-based swap; membership in a swap association in a

    category reserved for dealers; providing marketing materials

    describing the type of swaps or security-based swaps the party is

    willing to enter into; and generally expressing a willingness to

    offer or provide a range of products or services that include swaps

    or security-based swaps. See Proposing Release, 75 FR at 80178.

    \285\ See part II.A.2.a, supra.

    \286\ While the Proposing Release identified ``membership in a

    swap association in a category reserved for dealers'' as a factor in

    connection with the ``holding out'' and ``commonly known'' tests, we

    recognize that, depending on the applicable facts and circumstances,

    such membership may not be sufficient to cause a person to be a

    security-based swap dealer if the person does nothing else to cause

    it to be considered a dealer.

    ---------------------------------------------------------------------------

    6. Requests for Exclusions From the Dealer Definitions

    Certain commenters have sought to exclude entire categories of

    persons from the dealer definitions, notwithstanding that some persons

    in those categories may engage in the activities set forth in the

    statutory definition (as further defined by the Commissions).\287\ The

    final rules nonetheless do not incorporate categorical exclusions of

    persons from the dealer definitions because the statutory definitions

    provide that ``any person'' who engages in the activities enumerated in

    the definitions is covered by the dealer definitions, unless the

    person's activities fall within one of the statutory exceptions.\288\

    In this regard, it is significant that the exceptions in the dealer

    definitions depend on whether a person engages in certain types of swap

    or security-based swap activity, not on other characteristics of the

    person. That is, the exceptions apply for swaps between an insured

    depository institution and its customers in connection with originating

    loans,\289\ swaps or security-based swaps entered into not as a part of

    a regular business,\290\ and swap or security-based swap dealing that

    is below a de minimis

    [[Page 30620]]

    level.\291\ The Dodd-Frank Act does not exclude any category of persons

    from the coverage of the dealer definitions; rather, it excludes

    certain activities from the dealer analysis.

    ---------------------------------------------------------------------------

    \287\ See part II.A.2.f, supra.

    \288\ See CEA section 1a(49), 7 U.S.C. 1a(49); Exchange Act

    section 3(a)(71), 15 U.S.C. 78c(a)(71).

    \289\ See CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A).

    \290\ See CEA section 1a(49)(C), 7 U.S.C. 1a(49)(C); Exchange

    Act section 3(a)(71)(C), 15 U.S.C. 78c(a)(71)(C).

    \291\ See CEA section 1a(49)(D), 7 U.S.C. 1a(49)(D); Exchange

    Act section 3(a)(71)(D), 15 U.S.C. 78c(a)(71)(D).

    ---------------------------------------------------------------------------

    Given that the statutory dealer definitions focus on a person's

    activity, the Commissions believe that it is appropriate to determine

    whether a person meets any of the tests set forth in those statutory

    definitions, and thus is acting as a swap dealer or security-based swap

    dealer, on a case-by-case basis reflecting the applicable facts and

    circumstances.\292\ If a person's swap or security-based swap

    activities are of a nature to be covered by the statutory definitions,

    and those activities are not otherwise excluded, then the person is

    covered by the definitions. The contrary is equally true--a person who

    is not engaged in activities covered by the statutory definitions, or

    whose activities are excluded from the definition, is not covered by

    the definitions.\293\ The per se exclusions requested by the commenters

    have no foundation in the statutory text, and have the potential to

    lead to arbitrary line drawing that may result in disparate regulatory

    treatment and inappropriate competitive advantages.\294\

    ---------------------------------------------------------------------------

    \292\ The Commissions believe that a facts and circumstances

    approach is particularly appropriate here, where the broad terms of

    the statutory dealer definitions indicate that the Commissions

    should apply their expertise and discretion to interpret the

    statutory text.

    \293\ For example, a manufacturer, producer, processor, or

    merchant that enters into swaps to hedge its currency or interest

    rate risk, absent any facts and circumstances establishing dealing

    activity, is not a swap dealer.

    \294\ In response to the commenters concerns, the Commissions

    have adopted certain tailored exclusions of certain types of swaps

    and security-based swaps in the final rule.

    ---------------------------------------------------------------------------

    The final rules particularly do not include any exclusions for

    aggregators of swaps or other persons that use swaps in connection with

    the physical commodity markets, including swaps in connection with the

    generation, transmission and distribution of electricity. It is likely,

    though, that a significant portion of the financial instruments used

    for risk management by such persons are forward contracts in

    nonfinancial commodities that are excluded from the definition of the

    term ``swap.'' \295\ Such forward contracts are not relevant in

    determining whether a person is a swap dealer.

    ---------------------------------------------------------------------------

    \295\ A coalition of not-for-profit power utilities and electric

    cooperatives has advised that it plans to submit a request for an

    exemption for transactions between entities described in section

    201(f) of the Federal Power Act, as contemplated by section 722(f)

    of the Dodd-Frank Act. See letter from NFPEEU. Separately, some

    regional transmission organizations and independent systems

    operators have expressed interest in submitting an exemption

    application to the CFTC as well. See generally section 722(e) of the

    Dodd-Frank Act. Such exemptions, if granted after notice and comment

    pursuant to CEA section 4(c), 7 U.S.C. 6(c), could further address

    commenters' concerns in this regard.

    ---------------------------------------------------------------------------

    B. ``Swap Dealer'' Exclusion for Swaps in Connection With Originating a

    Loan

    1. Proposed Approach

    The statutory definition of the term ``swap dealer'' excludes an

    insured depository institution (``IDI'') ``to the extent it offers to

    enter into a swap with a customer in connection with originating a loan

    with that customer.'' \296\ This exclusion does not appear in the

    definition of the term ``security-based swap dealer.''

    ---------------------------------------------------------------------------

    \296\ See CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A).

    ---------------------------------------------------------------------------

    Proposed CFTC Regulation Sec. 1.3(ggg)(5) would implement this

    statutory exclusion by providing that an IDI's swaps with a customer in

    connection with originating a loan to that customer are disregarded in

    determining if the IDI is a swap dealer. In order to prevent evasion,

    the proposed rule further provided that the statutory exclusion does

    not apply where the purpose of the swap is not linked to the financial

    terms of the loan; the IDI enters into a ``sham'' loan; or the

    purported ``loan'' is actually a synthetic loan such as a loan credit

    default swap or loan total return swap.

    1. Commenters' Views

    Nearly all the commenters on this issue were IDIs seeking a broad

    interpretation of the exclusion. The commenters addressed four primary

    issues: (i) The type of swaps that should be covered by the exclusion;

    (ii) the time period during which parties would be required to enter

    into the swap in order for the swap to be considered to be ``in

    connection with originating a loan;'' (iii) which transactions should

    be deemed to be ``loans'' for purposes of the exclusion; and (iv) which

    entities should be included within the definition of IDI.

    First, regarding the type of swap that should be covered by the

    exclusion, as proposed, Sec. 1.3(ggg)(5) would require that the rate,

    asset, liability or other notional item underlying the swap be, or be

    directly related to, a financial term of the loan (such as the loan's

    principal amount, duration, rate of interest or currency). Some

    commenters agreed with the principle of limiting the exclusion to swaps

    that are connected to the financial terms of the loan, stating that the

    exclusion should cover any swap between a borrower and the lending IDI,

    so long as the swap's notional amount is no greater than the loan

    amount, the swap's duration is no longer than the loan's duration, and

    the swap's index and payment dates match the index and payment dates of

    the loan.\297\ Another commenter, agreeing with the proposed approach,

    said that there is no basis to extend the loan origination exclusion to

    swaps related to the borrower's business risks, as opposed to the

    financial terms of the loan.\298\

    ---------------------------------------------------------------------------

    \297\ See letters from Branch Banking & Trust Company (``BB&T'')

    dated February 3, 2011 (``BB&T I''), B&F Capital Markets, Inc.

    (``B&F Capital'') dated February 18, 2011 (``B&F Capital I''),

    Capital One Financial Corporation (``Capital One'') and Capstar Bank

    (``Capstar''); see also joint letter from Atlantic Capital Bank,

    Cobiz Bank, Cole Taylor Bank, Commerce Bank, N.A., East West Bank,

    First Business Bank, First National Bank of Pennsylvania, Heartland

    Financial USA, Inc., Old National Bancorp, Peoples Bancorp of North

    Carolina, Inc., Susquehanna Bank, The PrivateBank and Trust Co, The

    Savannah Bank, N.A., The Washington Trust Company, Trustmark

    National Bank, UMB Financial Corporation, Valley National Bank,

    Webster Bank NA, WesBanco Bank (``Regional Banks'') (general support

    for limitation to swaps connected to financial terms of the loan).

    \298\ See letter from Better Markets I.

    ---------------------------------------------------------------------------

    Other commenters, though, said that this limitation to swaps

    connected to the financial terms of the loan was inappropriate or

    inconsistent with the Dodd-Frank Act, and that any swap required by the

    loan agreement or required by the IDI as a matter of prudent lending

    should be covered by the exclusion.\299\ Some of the commenters arguing

    for the broader exclusion emphasized that the exclusion should be

    available for any swap with the lending IDI which reduces the

    borrower's risks, such as a commodity swap the borrower uses for

    hedging, because reduction of commodity price risks faced by the

    borrower also reduces the risk that the loan will not be repaid to the

    IDI.\300\ Commenters said that if the exclusion does not apply to swaps

    hedging the borrower's commodity price risks, then only IDIs that are

    able to create a separately capitalized affiliate will be able to offer

    commodity swaps (because section 716 of the Dodd-Frank Act limits the

    ability of IDIs to offer commodity swaps), thereby reducing the

    availability of commodity swaps to

    [[Page 30621]]

    borrowers that are smaller companies.\301\

    ---------------------------------------------------------------------------

    \299\ See letters from BOK dated February 18, 2011 (``BOK II''),

    FSR I, ISDA I, Midsize Banks, OCC Staff at 6 (noting that ``[l]oan

    underwriting criteria for community and mid-size banks * * * may

    require, as a condition of the loan, that the borrower be hedged

    against the commodity price risks incidental to its business'') and

    White & Case LLP (``White & Case'') and joint letter from Senator

    Stabenow and Representative Lucas.

    \300\ See letters from BOK II, FSR I, OCC Staff and White &

    Case.

    \301\ See letters from ABA I and BOK I. Other commenters

    addressed the relationship between the swap dealer definition and

    section 619 of the Dodd-Frank Act (the ``Volcker Rule''). See joint

    letter from Capital One, Fifth Third Bancorp and Regions Financial

    Corporation.

    ---------------------------------------------------------------------------

    Second, regarding timing, the proposed rule requested comment on

    whether this exclusion should apply only to swaps that are entered into

    contemporaneously with the IDI's origination of the loan (and if so,

    how ``contemporaneously'' should be defined for this purpose), or

    whether this exclusion also should apply to swaps entered into during

    part or all of the duration of the loan. In response, commenters said

    that the exclusion should apply to swaps entered into in anticipation

    of a loan or at any time during the loan term.\302\ Commenters said

    that application of the exclusion throughout the duration of the loan

    would give IDIs and borrowers flexibility as to when to fix interest

    rates in fixed/floating swaps relating to loans and would allow

    borrowers to make other hedging decisions over a longer time

    period.\303\ Commenters also said that loans such as construction

    loans, equipment loans and committed loan facilities may allow for

    draws of loan principal over an extended period of time, and that swaps

    entered into by the borrower and lending IDI through the course of such

    a loan should be covered by the exclusion.\304\

    ---------------------------------------------------------------------------

    \302\ See letters from BB&T I, B&F Capital I, BOK II, Capital

    One, Capstar, FSR I, Midsize Banks, Manufacturers and Traders Trust

    Company (``M&T'') dated June 3, 2011 (``M&T I'') and September 28,

    2011 (``M&T II''), Peoples Bank Co. (``Peoples Bank''), Regional

    Banks and White & Case.

    \303\ See letters from B&F Capital I, BOK II, Capital One,

    Capstar and M&T I and M&T II.

    \304\ See letters from FSR dated October 17, 2011 (``FSR VI''),

    M&T II and Wells Fargo Bank, N.A. (``Wells Fargo'') dated August 16,

    2011 (``Wells Fargo II'').

    ---------------------------------------------------------------------------

    Third, as to which transactions should be deemed ``loans'' for

    purposes of the exclusion, the proposal said that the exclusion should

    be available in connection with all transactions by which an IDI is a

    source of funds to a borrower, including, for example, loan

    syndications, participations and refinancings. Commenters agreed that

    the exclusion should be available for IDIs that are in a loan

    syndicate, purchasers of a loan, assignees of a loan or participants in

    a loan.\305\ On loan syndications and participations in particular, one

    commenter said that the exclusion should be available even if the

    notional amount of the swap is more than the amount of the loan tranche

    assigned to the IDI, so long as the swap notional amount is not more

    than the entire amount of the loan.\306\ Another commenter said that

    the exclusion should not be available if the IDI's participation in the

    loan drops below a minimum level (such as 20 percent) because such use

    of the exclusion by minimally-participating IDIs would invite

    abuse.\307\

    ---------------------------------------------------------------------------

    \305\ See letters from BB&T I, Midsize Banks, Regional Banks and

    White & Case; see also letter from Loan Market Association

    (providing background information on loan participations).

    \306\ See letter from Regional Banks.

    \307\ See letter from Better Markets I.

    ---------------------------------------------------------------------------

    Some commenters said that other types of transactions also should

    be treated as ``loans'' for purposes of the exclusion. The transactions

    cited by commenters in this regard include leases, letters of credit,

    financings documented as sales of financial assets, bank qualified tax

    exempt loans and bonds that are credit enhanced by an IDI.\308\ Other

    commenters said the exclusion should apply where entities related to an

    IDI provide financing, such as loans or financial asset purchases by

    bank-sponsored commercial paper conduits where the IDI provides

    committed liquidity,\309\ and transactions where a special purpose

    entity formed by an IDI is the source of financing and enters into the

    swap.\310\ Some commenters said the exclusion should encompass all

    transactions where an IDI facilitates a financing,\311\ or all

    extensions of credit by an IDI,\312\ or all transactions where an IDI

    provides risk mitigation to a borrower.\313\

    ---------------------------------------------------------------------------

    \308\ See letters from BB&T I, Capital One, FSR I, M&T I,

    Midsize Banks and Regional Banks.

    \309\ See letter from FSR I.

    \310\ See letter from Midsize Banks.

    \311\ See letters from Pacific Coast Bankers' Bancshares

    (``PCBB'') and Regional Banks.

    \312\ See letters from FSR I and Midsize Banks.

    \313\ See letter from PCBB.

    ---------------------------------------------------------------------------

    Fourth, with respect to the types of financial institutions that

    are eligible for the loan origination exclusion, three commenters said

    that IDIs, for purposes of this exclusion, encompass more than banks or

    savings associations with federally-insured deposits. The Farm Credit

    Council said the exclusion should be extended to Farm Credit System

    institutions because one of these institutions enters into interest

    rate swaps with borrowing customers identical in function to those

    offered by commercial banks and savings associations in connection with

    loans, and the institutions are subject to similar regulatory

    requirements and covered by a similar insurance regime.\314\ Another

    commenter said that the exclusion should be extended to other regulated

    financial institutions, such as insurers, so as not to create an

    unlevel playing field.\315\ And the Federal Home Loan Banks said that

    the exclusion should be available to them because they are subject to

    similar regulatory oversight and capital standards and engage in a

    similar function of extending credit as do commercial banks and savings

    associations.\316\ In addition, some commenters said the exclusion

    should be broadly construed as a general matter, to encourage

    competition in the swap market between smaller and larger banks and to

    increase borrowers' choice among potential swap providers.\317\

    ---------------------------------------------------------------------------

    \314\ Consequently, the Farm Credit Council argued, disallowing

    these institutions from using the exclusion would give commercial

    banks and savings associations a competitive advantage in

    agricultural lending. See letters from Farm Credit Council I and

    dated February 17, 2012 (``Farm Credit Council II''). Another

    commenter argued that, to the contrary, making Farm Credit System

    institutions eligible for the exclusion would confer an

    inappropriate competitive advantage on those institutions. See

    letter from ABA dated February 14, 2012 (``ABA II''). This commenter

    said that Farm Credit System institutions have certain advantages

    over other IDIs, and the commenter asserted that Farm Credit System

    institutions were left out of the statutory language of the

    exclusion in order that they would not receive additional

    competitive advantages. See id.

    \315\ See letter from NAIC.

    \316\ See letter from FHLB I. The Credit Union National

    Association said that the Federal Home Loan Banks should not be

    covered by the swap dealer definition because they do not enter into

    swaps for their own account as part of a regular business. See

    letter from CUNA.

    \317\ See letters from BB&T I, B&F Capital dated June 1, 2011

    (``B&F Capital II''), Capital One, Capstar, M&T I and Peoples Bank.

    ---------------------------------------------------------------------------

    Two commenters asked for clarification of the following technical

    points in the proposed rule: (i) Whether a swap would be covered by the

    exclusion even if it does not hedge all the risks under the loan, (ii)

    whether a swap that is within the exclusion could continue to be

    treated as covered by the exclusion by an IDI if the IDI transfers the

    loan, and (iii) whether an IDI should count swaps covered by the

    exclusion in determining if its dealing activity is above the de

    minimis thresholds.\318\ Another commenter asked whether an IDI with

    swaps that are covered by the exclusion could be a swap dealer based on

    other dealing activity.\319\ And others asked whether the exclusion

    would cover swaps used by an IDI to hedge its risks arising from a loan

    (i.e., a swap which the IDI enters into with a party other than the

    loan borrower).\320\

    ---------------------------------------------------------------------------

    \318\ See letters from FSR VI and Midsize Banks.

    \319\ See letter from Better Markets I.

    \320\ See letters from B&F Capital I, FSR I, ISDA I, M&T I and

    Midsize Banks.

    ---------------------------------------------------------------------------

    3. Final Rule

    The CFTC believes that the extent of this exclusion should be

    determined by

    [[Page 30622]]

    the language of the statutory definition, which relates to an IDI that

    ``offers to enter into a swap with a customer in connection with

    originating a loan with that customer.'' The expansive interpretation

    of the exclusion advanced by some commenters, however, would read the

    statute to exclude almost any swap that an IDI enters into with a loan

    customer. That is not the exclusion that was enacted. Instead, we

    interpret the statutory phrase ``enter into a swap with a customer in

    connection with originating a loan with that customer'' to mean that

    the swap is directly connected to the IDI's process of originating the

    loan to the customer.

    Because of the statute's direct reference to ``originating'' the

    loan, it would be inappropriate to construe the exclusion as applying

    to all swaps entered into between an IDI and a borrower at any time

    during the duration of the loan. If this were the intended scope of the

    statutory exclusion, there would be no reason for the text to focus on

    swaps in connection with ``originating'' a loan. The CFTC recognizes

    the concern expressed by commenters that: (i) there be flexibility

    regarding when the IDI and borrower enter into a swap relating to a

    loan, and (ii) the expectation when an IDI originates a loan with a

    customer is often that the customer will enter into a swap with the IDI

    when there is a subsequent advance, or a draw, of principal on the

    loan. We do not believe, however, that the statutory term

    ``origination'' can reasonably be stretched to cover the entire term of

    every loan that an IDI makes to its customers. At some point, the

    temporal distance renders the link to loan origination too attenuated,

    and the risk of evasion too great, to support the exclusion. In order

    to balance these competing and conflicting considerations, the final

    rule applies the exclusion to any swap that otherwise meets the terms

    of the exclusion and is entered into no more than 90 days before or 180

    days after the date of execution of the loan agreement, or no more than

    90 days before or 180 days after the date of any transfer of principal

    to the borrower from the IDI (e.g., a draw of principal) pursuant to

    the loan, so long as the aggregate notional amount of the swaps in

    connection with the financial terms of the loan at any time is no more

    than the aggregate amount of the borrowings under the loan at that

    time.\321\

    ---------------------------------------------------------------------------

    \321\ We note that because the exclusion is available within the

    specified time period around the execution of the loan agreement and

    any draw of principal under the loan, any amendment, restructuring,

    extension or other modification of the loan will, in itself, neither

    preclude application of the exclusion nor expand application of the

    exclusion.

    ---------------------------------------------------------------------------

    Since a loan involves the repayment of funds to the IDI on

    particular terms, a swap that relates to those terms of repayment

    should be covered by the exclusion. In addition, we recognize that, as

    stated by commenters, requirements in an IDI's loan underwriting

    criteria relating to the borrower's financial stability are an

    important part of ensuring that loans are repaid.\322\ Therefore, the

    final rule modifies the proposed rule to provide that the exclusion

    applies to swaps between an IDI and a loan borrower that are connected

    to the financial terms of the loan, such as, for example, the loan's

    duration, interest rate, currency or principal amount, or that are

    required under the IDI's loan underwriting criteria to be in place as a

    condition of the loan in order to hedge commodity price risks

    incidental to the borrower's business.\323\ The first category of swaps

    generally serve to transform the financial terms of a loan for purposes

    of adjusting the borrower's exposure to certain risks directly related

    to the loan itself, such as risks arising from changes in interest

    rates or currency exchange rates. The second category of swaps mitigate

    risks faced by both the borrower and the lender, by reducing risks that

    the loan will not be repaid. Thus, both types of swaps are directly

    related to repayment of the loan. Although some commenters said that

    this exclusion should also apply to other types of swaps, we believe it

    would be inappropriate to construe this exclusion as encompassing all

    swaps that are connected to a borrower's other business activities,

    even if the loan agreement requires that the borrower enter into such

    swaps or otherwise refers to them.\324\ In contrast to a swap that

    transforms the financial terms of a loan or is required by the IDI's

    loan underwriting criteria to reduce the borrower's commodity price

    risks, other types of swaps serve a more general risk management

    purposes by reducing other risks related to the borrower or the loan.

    If the purpose of the exclusion were to cover the broad range of swaps

    cited by some commenters (such as all swaps reducing a borrower's

    business risks), then the terms of the statute limiting the exclusion

    to swaps that are ``in connection with originating a loan with that

    customer'' would be superfluous.\325\ To give effect to the statutory

    text, the exclusion is limited to a swap that is connected to the

    financial terms of the loan or is required by the IDI's loan

    underwriting criteria to to be in place as a condition of the loan in

    order to hedge commodity price risks incidental to the borrower's

    business.

    ---------------------------------------------------------------------------

    \322\ See letter from OCC Staff.

    \323\ The final rule provides that the second category of swaps

    must hedge a price risk related to a commodity other than an

    excluded commodity because if the price risk relates to an excluded

    commodity (such as an interest rate) the swap must be connected to

    the financial terms of the loan in order to be covered by the

    exclusion.

    \324\ On the other hand, there is no requirement that the loan

    agreement reference a swap in order for the swap to be excluded, if

    the swap otherwise qualifies for the exclusion.

    \325\ Also, we believe that the broader range of swaps serving

    general risk management purposes are more likely to involve concerns

    regarding market transparency and appropriate business conduct

    practices addressed by swap dealer regulation than are the narrower

    range of swaps that are encompassed by the exclusion.

    ---------------------------------------------------------------------------

    Regarding the types of transactions that will be treated as a

    ``loan'' for purposes of the exclusion, courts have defined the term

    ``loan'' in other statutory contexts based on the settled meaning of

    the term under common law. This definition encompasses any contract by

    which one party transfers a defined quantity of money and the other

    party agrees to repay the sum transferred at a later date.\326\ Rather

    than examine at this time the many particularized examples of financing

    transactions cited by some commenters, the term ``loan'' for purposes

    of this exclusion should be interpreted in accordance with this settled

    legal meaning.\327\

    ---------------------------------------------------------------------------

    \326\ See, e.g., In Re Renshaw, 222 F.3d 82, 88 (2d Cir. 2000)

    (``Because Congress did not define the term ``loan'' for [11 U.S.C.]

    Sec. 523(a)(8), we must interpret it according to its settled

    meaning under common law. The classic definition of a loan [is] * *

    * as follows: To constitute a loan there must be (i) a contract,

    whereby (ii) one party transfers a defined quantity of money, goods,

    or services, to another, and (iii) the other party agrees to pay for

    the sum or items transferred at a later date.'') (citing In re Grand

    Union Co., 219 F. 353, 356 (2d Cir. 1914)).

    \327\ The final rule adopts provisions from the proposed rule

    that, in order to prevent evasion, the statutory exclusion does not

    apply where the IDI originates a ``sham'' loan; or the purported

    ``loan'' is actually a synthetic loan such as a loan credit default

    swap or loan total return swap. See CFTC Regulation Sec.

    1.3(ggg)(5)(iii).

    ---------------------------------------------------------------------------

    As stated in the proposed rule, this exclusion is available to all

    IDIs that are a source of a transfer of money to a borrower pursuant to

    a loan. The final rule adopts provisions from the proposed rule that

    the exclusion is available to an IDI that is a source of money by being

    part of a loan syndicate, being an assignee of a loan, obtaining a

    participation in a loan, or purchasing a loan.\328\ However, the

    proposed rule did

    [[Page 30623]]

    not state explicitly how the notional amount of a swap subject to the

    exclusion must relate to the amount of money provided by an IDI that is

    in a loan syndicate or is an assignee of, participant in or purchaser

    of a loan. In this regard, some commenters said that a borrower and the

    IDIs in a lending syndicate need flexibility to allocate responsibility

    for the swap(s) related to the loan as they may agree.\329\ We believe

    that, to allow for this flexibility, the exclusion may apply to a swap

    (which is otherwise covered by the exclusion) even if the notional

    amount of the swap is different from the amount of the loan tranche

    assigned to the IDI. However, we also agree with a commenter that the

    IDI should have a substantial participation in the loan.\330\ The

    requirement of substantial participation would prevent an IDI from

    applying the exclusion where the IDI makes minimal lending commitments

    in multiple loan syndicates where it offers swaps, causing its swap

    activity to be far out of proportion to its loan activity.\331\

    ---------------------------------------------------------------------------

    \328\ See CFTC Regulation Sec. 1.3(ggg)(5)(ii). As is also

    stated in the Proposing Release, if an IDI were to transfer its

    participation in a loan to a non-IDI, then the non-IDI would not be

    able to claim this exclusion, regardless of the terms of the loan or

    the manner of the transfer. Similarly, a non-IDI that is part of a

    loan syndicate with IDIs would not be able to claim the exclusion.

    \329\ See, e.g., letter from Regional Banks.

    \330\ See letter from Better Markets I. This commenter suggested

    a minimal threshold of at least 20 percent of the loan. However, we

    believe that a 10 percent commitment constitutes a substantial

    participation in the loan which supports offering of a swap up to

    the loan's full amount.

    \331\ For example, an IDI could act as a 0.1 percent participant

    in one hundred different loans in order to serve as the sole swap

    counterparty to the borrowers for hedging the borrowers' interest

    rate risk on the loans. Thus, by lending or committing to lend $100

    million, the IDI could apply the exclusion to swaps with an

    aggregate notional amount of $100 billion.

    ---------------------------------------------------------------------------

    Therefore, the final rule includes a provision that the exclusion

    may apply regardless of whether the notional amount of the swap is the

    same as the amount of the loan, but only if the IDI is the sole source

    of funds under the loan or is committed to be, under the applicable

    loan agreements, the source of at least 10 percent of the maximum

    principal amount under the loan.\332\ If the IDI does not meet this 10

    percent threshold, the final rule provides that the exclusion may apply

    only if the aggregate notional amount of all the IDI's swaps with the

    customer related to the financial terms of the loan is no more than the

    amount lent by the IDI to the customer.\333\ We also note that, in all

    cases, application of the exclusion requires that the aggregate

    notional amount of all swaps entered into by the borrower with any

    person in connection with the financial terms of the loan at any time

    is not more than the aggregate principal amount outstanding under the

    loan at that time.\334\

    ---------------------------------------------------------------------------

    \332\ See CFTC Regulation Sec. 1.3(ggg)(5)(i)(D)(1) and (2).

    \333\ See CFTC Regulation Sec. 1.3(ggg)(5)(i)(D)(3).

    \334\ See CFTC Regulation Sec. 1.3(ggg)(5)(i)(E). Paragraphs

    (D)(3) and (E) of this regulation refer to all swaps ``in connection

    with the financial terms of the loan'' in order to clarify that only

    such swaps are relevant in this regard. For example, if the IDI were

    to enter into a swap with the customer that is not in connection

    with the loan's financial terms, the swap would not be relevant

    because the exclusion would not apply to the swap.

    ---------------------------------------------------------------------------

    We also reiterate the interpretation in the Proposing Release that

    the word ``offer'' in this exclusion includes scenarios where the IDI

    requires the customer to enter into a swap, or where the customer asks

    the IDI to enter into a swap, specifically in connection with a loan

    made by that IDI.

    We also continue to emphasize, as stated in the Proposing Release,

    that the statutory language of the exclusion limits its availability to

    only IDIs as defined in the statute. Regarding some commenters'

    statements about the competitive effect of this interpretation of the

    term ``insured depository institution,'' we believe that the scope of

    application of the swap dealer definition to various entities should be

    treated in the de minimis exception, which is available to all persons.

    In order to provide clarification in response to certain technical

    questions raised by commenters, we note that whether a swap hedges all

    of the risk, or only some of the risk, of a loan is not relevant to

    application of the exclusion. Nor is it relevant to the exclusion if

    the IDI later transfers or terminates the loan in connection with which

    the swap was entered into, so long as the swap otherwise qualifies for

    the exclusion and the loan was originated in good faith and was not a

    sham.\335\ Further, swaps that are covered by the exclusion should not

    be considered in determining if an IDI exceeds the de minimis level of

    swap dealing activity, because the statute provides that swaps covered

    by the exclusion should not be considered in determining if an IDI is a

    swap dealer, and the de minimis exception provides that it considers

    the ``quantity of [a person's] swap dealing.'' \336\ The application of

    the exclusion to swaps entered into by an IDI in connection with the

    origination of loans, however, does not mean that the IDI could not be

    a swap dealer because of other of the IDI's activities that constitute

    swap dealing. Regarding swaps used by an IDI to hedge or lay off its

    risks arising from a loan, we do not believe it is appropriate to treat

    such swaps as covered by the exclusion, because the statute explicitly

    limits the exclusion to swaps ``with a customer,'' which such hedging

    swaps are not. However, a swap that an IDI enters into for the purpose

    of hedging or laying off the risk of a swap that is covered by the IDI

    exclusion will not be considered in the de minimis determination, or

    otherwise in evaluating whether the IDI is covered by the swap dealer

    definition.\337\

    ---------------------------------------------------------------------------

    \335\ On the other hand, if the IDI were to transfer the swap

    (but not the loan) to another IDI, and the IDI that is the

    transferee of the swap is not a source of money to the borrower

    under the loan, then the transferee IDI would not be able to apply

    the exclusion to the swap.

    \336\ See CEA sections 1a(49)(A) and 1a(49)(D), 7 U.S.C.

    1a(49)(A) and 1a(49)(D).

    \337\ An IDI that is seeking out swap counterparties to enter

    into swaps in order to hedge or lay off the risk of a swap that is

    subject to the IDI exclusion would generally not be accommodating

    demand for swaps or facilitating interest in swaps.

    ---------------------------------------------------------------------------

    Last, we believe it is appropriate to require that an IDI claiming

    the exclusion report its swaps that are covered by the exclusion to a

    swap data repository (``SDR''). This requirement is consistent with the

    prevailing practice that IDIs handle the documentation of loans made to

    borrowers, and will provide for consistent reporting of swaps that are

    covered by the exclusion, thereby allowing the CFTC and other

    regulators to monitor the use of the exclusion.

    In sum, the final rule balances the need for flexibility in

    response to existing lending practices, consistent with the constraints

    imposed by the statutory text as enacted, against the risk of

    establishing a gap in the regulatory framework enacted in Title

    VII.\338\ It provides that the exclusion may be claimed by a person

    that meets the following conditions: (i) The person is an IDI; (ii) the

    IDI enters into a swap with the borrower that does not extend beyond

    the termination of the loan; (iii) the swap is connected to the

    financial terms of the loan or is required by the IDI's loan

    underwriting criteria to to be in place as a condition of the loan in

    order to hedge commodity price risks incidental to the borrower's

    business; (iv) the loan is within the common law meaning of ``loan''

    and it is not a sham or a synthetic loan; (v) the IDI is the source of

    money to the borrower in connection with the loan either directly, or

    (so long as the IDI is the source of at least 10 percent of the entire

    amount of the loan) through syndication, participation, assignment,

    purchase, refinancing or otherwise; (vi) the IDI

    [[Page 30624]]

    enters into the swap with the borrower within 90 days before or 180

    days after the date the execution of the loan agreement, or within 90

    days before or 180 days after any transfer of principal to the borrower

    from the IDI pursuant to the loan; (vii) the aggregate notional amount

    of all swaps entered into by the borrower with all persons in

    connection with the financial terms of the loan at any time is not more

    than the aggregate amount of the borrowings under the loan at that

    time; and (viii) the IDI agrees to report the swap to an SDR.

    ---------------------------------------------------------------------------

    \338\ The final rule text in CFTC Regulation Sec.

    1.3(ggg)(5)(i) has been revised to conform the text of the rule to

    the statutory provision which refers to ``an insured depository

    institution [that] * * * enter[s] into a swap with a customer in

    connection with originating a loan with that customer.'' See CEA

    Sec. 1a(49)(A), 7 U.S.C. 1a(49)(A)

    ---------------------------------------------------------------------------

    An IDI that enters into swaps that do not meet these conditions,

    and thus do not qualify for the statutory exclusion, is not necessarily

    required to register as a swap dealer. Rather, the IDI would apply the

    statutory definition and the provisions of the rule (taking into

    account the applicable interpretive guidance set forth in this Adopting

    Release), solely with respect to its swaps that are not subject to the

    IDI exclusion, in order to determine whether it is engaged in swap

    dealing activity that exceeds the de minimis threshold.

    C. Application of Dealer Definitions to Legal Persons and to Inter-

    Affiliate Swaps and Security-Based Swaps

    1. Proposed Approach and Commenters' Views

    In the Proposing Release, the Commissions preliminarily concluded

    that designation as a dealer would apply on an entity-level basis

    (rather than to a trading desk or other business unit that is not

    organized as a separate legal person), and that an affiliated group of

    legal persons could include more than one dealer.\339\ The Proposing

    Release also stated that the dealer analysis should consider the

    economic reality of swaps and security-based swaps between affiliates,

    and preliminarily noted that swaps or security-based swaps ``between

    persons under common control may not involve the interaction with

    unaffiliated persons that we believe is a hallmark of the elements of

    the definitions that refer to holding oneself out as a dealer or being

    commonly known as a dealer.'' \340\

    ---------------------------------------------------------------------------

    \339\ See Proposing Release, 75 FR at 80183.

    \340\ Id. The Proposing Release further noted that sections

    721(c) and 761(b)(3) give the Commissions anti-evasion authority, to

    the extent that an entity were to seek to use transactions between

    persons under common control to avoid one of the dealer definitions.

    See id. (erroneously referring to section 721(c) as section

    721(b)(3).

    ---------------------------------------------------------------------------

    Commenters supported the view that swaps and security-based swaps

    among affiliates should be excluded from the dealer analysis.\341\ A

    number of commenters took the view that the dealer definitions should

    not apply when there is common control between counterparties, or when

    common control is combined with the consolidation of financial

    statements.\342\ Some commenters suggested that this interpretation

    regarding the scope of the dealer definitions should incorporate

    concepts of affiliation that are found in other statutory and

    regulatory provisions.\343\ Several commenters also opposed the

    suggestion (raised as part of the Proposing Release's request for

    comments) that this interpretation be limited to transactions among

    wholly owned subsidiaries.\344\

    ---------------------------------------------------------------------------

    \341\ See, e.g., letters from API I, COPE I, ISDA I, Midsize

    Banks, ONEOK, Inc. (``ONEOK'') and Peabody.

    Several commenters explained the widespread use of central

    hedging desks to allocate risk within affiliate groups or to gather

    risk from within a group and lay that risk off on the market. See,

    e.g., letters from EEI/EPSA, Kraft Foods Inc. (``Kraft''), MetLife

    and Prudential Financial, Inc. (``Prudential'') dated February 17,

    2011 (``Prudential I'').

    Some commenters particularly stated that the use of a single

    entity to face the market on behalf of an affiliate group had

    several risk-reducing and efficiency-enhancing benefits, and that

    those benefits would be lost if the dealer definitions were to lead

    corporate groups to avoid using central trading desks and instead

    require each affiliate to face the market as an independent end-

    user. See letters from FSR I, Philip Morris International Inc.

    (``Philip Morris''), Shell Trading dated June 3, 2011 (``Shell

    Trading II'') and Utility Group, and joint letter from ABA

    Securities Association, American Council of Life Insurers

    (``ACLI''), FSR, Futures Industry Association (``FIA''), Institute

    of International Bankers, ISDA and SIFMA (``Financial

    Associations'').

    Some commenters also stated that legislative history suggested

    that Congress did not intend that the dealer definition capture

    transactions involving the use of an affiliate to hedge commercial

    risk. See letters from CDEU and Prudential I.

    \342\ See letters from CDEU (common control), Financial

    Associations (common control and consolidation), MetLife

    (consolidation), ONEOK (common control, evaluated based on whether

    the trading interests of the entities are aligned) and Prudential I

    (citing CFTC letter interpretation regarding common control).

    \343\ See, e.g., letters from EDF Trading (proposing definition

    from regulations promulgated by the Federal Energy Regulatory

    Commission) and Peabody (proposing definition of ``affiliate'' used

    in federal securities laws) and joint letter from the Bank of Tokyo-

    Mitsubishi UFJ, Ltd., Mizuho Corporate Bank, Ltd. and Sumitomo

    Mitsui Banking Corp. (suggesting use of control definition in Bank

    Holding Company Act).

    \344\ See, e.g., letters from Kraft and ONEOK.

    ---------------------------------------------------------------------------

    2. Final Interpretation and Rule

    a. Application to Legal Persons

    Consistent with the Proposing Release, the Commissions interpret

    ``person'' as used in the swap dealer and security-based swap dealer

    definitions to refer to a particular legal person. Accordingly, the

    dealer definitions will apply to the particular legal person performing

    the dealing activity, even if that person's dealing activity is limited

    to a trading desk or discrete business unit,\345\ unless the person is

    able to take advantage of a limited designation as a dealer.\346\

    ---------------------------------------------------------------------------

    \345\ Within an affiliated group of companies, however, only

    those legal persons that engage in dealing activities will be

    designated as dealers; that designation will not be imputed to other

    non-dealer affiliates or to the group as a whole. A single affiliate

    group may, however, have multiple swap or security-based swap

    dealers.

    \346\ Limited designation as a dealer is addressed in more

    detail below in part II.E.

    ---------------------------------------------------------------------------

    b. Application to Inter-Affiliate Swaps and Security-Based Swaps

    The final rules codify exclusions from the dealer definitions for a

    person's swap or security-based swap activities with certain

    affiliates.\347\ These rules are consistent with the Proposing

    Release's recognition of the need to consider the economic reality of

    any swaps or security-based swaps that a person enters into with

    affiliates. Market participants may enter into such inter-affiliate

    swaps or security-based swaps for a variety of purposes, such as to

    allocate risk within a corporate group or to transfer risks within a

    corporate group to a central hedging or treasury entity.

    ---------------------------------------------------------------------------

    \347\ See CFTC Regulation Sec. 1.3(ggg)(6)(i); Exchange Act

    rule 3a71-1(d). A person's market-facing swap or security-based swap

    activity may still cause that person to be a dealer, even if that

    market-facing activity is linked to the inter-affiliate activity, to

    the extent that the market-facing activity satisfies the dealer

    definition. However, a person's market-facing swap activity for

    hedging purposes as defined in CFTC Regulation Sec.

    1.3(ggg)(6)(iii) would not cause that person to be a dealer.

    ---------------------------------------------------------------------------

    Under the final rules, the dealer analysis will not apply to swaps

    and security-based swaps between majority-owned affiliates.\348\ When

    the economic interests of those affiliates are aligned adequately--as

    would be found in the case of majority-ownership--such swaps and

    security-based swaps serve to allocate or transfer risks within an

    affiliated group, rather than to move those risks out of the group to

    an unaffiliated third party. For this reason, and as contemplated by

    the Proposing Release,\349\ we do not believe that such

    [[Page 30625]]

    swaps and security-based swaps involve the interaction with

    unaffiliated persons to which dealer regulation is intended to apply.

    ---------------------------------------------------------------------------

    \348\ See CFTC Regulation Sec. 1.3(ggg)(6)(i); Exchange Act

    rule 3a71-1(d)(1). For the purposes of these rules, the

    counterparties are majority-owned affiliates if one party directly

    or indirectly holds a majority ownership interest in the other, or

    if a third party directly or indirectly holds a majority interest in

    both, based on holding a majority of the equity securities of an

    entity, or the right to receive upon dissolution or the contribution

    of a majority of the capital of a partnership. See CFTC Regulation

    Sec. 1.3(ggg)(6)(i); Exchange Act rule 3a71-1(d)(2).

    \349\ See Proposing Release, 75 FR at 80183 (noting that swaps

    or security-based swaps between affiliates ``may not involve the

    interaction with unaffiliated persons that we believe is a hallmark

    of the elements of the definitions that refer to holding oneself out

    as a dealer or being commonly known as a dealer'').

    ---------------------------------------------------------------------------

    The standard in the final rules differs from the standard suggested

    by the Proposing Release, which alluded to affiliates as legal persons

    under ``common control.'' This change is based on our further

    consideration of the issue, including consideration of comments that an

    inter-affiliate exclusion should be available when common control is

    combined with the consolidation of financial statements. Although we

    are not including a requirement that financial statements be

    consolidated--as we do not believe that the scope of this exclusion

    should be exposed to the risk of future changes in accounting

    standards--in our view a majority ownership standard is generally

    consistent with consolidation under GAAP.\350\ Absent majority

    ownership, we cannot be confident that there would be an alignment of

    economic interests that is sufficient to eliminate the concerns that

    underpin dealer regulation.

    ---------------------------------------------------------------------------

    \350\ See FASB ASC Section 810-10-25, Consolidation--Overall--

    Recognition (stating that consolidation is appropriate if a

    reporting entity has a controlling financial interest in another

    entity and a specific scope exception does not apply).

    ---------------------------------------------------------------------------

    In taking this approach, we have also considered alternatives

    suggested by commenters. For example, while one commenter suggested

    that we adopt a definition of ``affiliate'' as used in the securities

    laws,\351\ we believe that such an approach would be too broad for the

    purpose of this exclusion from dealing activity, given that common

    control by itself does not ensure that two entities' economic interests

    are sufficiently aligned.\352\

    ---------------------------------------------------------------------------

    \351\ See letter from Peabody. The commenter did not specify

    which definition of ``affiliate'' in the securities laws it was

    proposing. For example, Rule 405 of the Securities Act of 1933

    defines affiliate in terms of common control, see 17 CFR 230.405,

    and Section 20(a) of the Exchange Act takes a similar approach. The

    Investment Company Act of 1940 (``ICA'') defines affiliate to

    include entities with a common ownership interest as low as 5

    percent, ICA section 2(a)(3). Two other commenters proposed using a

    common control standard, perhaps also in reference to the Rule 405

    definition of ``affiliate.''

    \352\ The definitions of ``affiliate'' and ``control'' found in

    Rule 405 and other securities law provisions are appropriate in the

    context of the prophylactic and remedial provisions in which they

    are found. Rule 405, for example, uses the terms ``affiliate'' and

    ``control'' to identify those persons that have the power to effect

    registration of an issuer's securities, and the broad definitions

    ensure that the persons with that power actually fulfill their

    obligation to do so. By comparison, the exclusion of inter-affiliate

    swaps and security-based swaps from the dealer analysis should be

    more tightly focused to address situations in which counterparties

    have similar economic interests.

    Another commenter noted the definition of ``affiliate'' found

    in certain Federal Energy Regulation Commission regulations--which

    define ``affiliate'' in terms of a ten percent or five percent

    common ownership interest. See letter from EDF Trading. Those

    relatively low ownership thresholds, however, are intended to

    address different concerns regarding collusion and cross-

    subsidization, and do not appear appropriate for an interpretation

    that has the potential to reduce the counterparty and market

    protections provided by Title VII. See 18 CFR sections 35.36(a)(9),

    35.39, 366.2(b), 366.3.

    ---------------------------------------------------------------------------

    c. Application to Cooperatives

    Similar considerations apply, in certain situations, to cooperative

    entities that enter into swaps with their members in order to allocate

    risk between the members and the cooperative. Commenters identified two

    general types of such cooperatives--``cooperative associations of

    producers'' as defined in section 1a(14) of the CEA \353\ and

    cooperative financial entities such as Farm Credit System institutions

    and Federal Home Loan Banks.\354\ As is the case for affiliated groups

    of corporate entities, we believe that when one of these cooperatives

    enters into a swap with one of its members,\355\ the swap serves to

    allocate or transfer risks within an affiliated group, rather than to

    move those risks from the group to an unaffiliated third party, so long

    as the cooperative adheres to certain risk management practices.

    ---------------------------------------------------------------------------

    \353\ 7 U.S.C. 1a(14). A cooperative association of producers is

    at least 75 percent owned or controlled, directly or indirectly, by

    producers of agricultural products and must comply with the Capper-

    Volstead Act (referred to in the CEA as the Act of February 18,

    1922, 7 U.S.C. 291 and 292). See letters from Land O'Lakes II, NCFC

    I and NMPF.

    \354\ See letters from Farm Credit Council I and FHLB I. The NRU

    CFC qualifies as a cooperative financial entity, but we understand

    that it does not enter into a significant amount of swaps with its

    members; rather, it enters into swaps with unaffiliated third

    parties. See letter from NRU CFC I and meeting with NRU CFC on

    January 13, 2011.

    \355\ The term ``cooperative association of producers'' also

    includes any organization acting for a group of such associations

    and owned or controlled by such associations. See CEA section

    1a(14), 7 U.S.C. 1a(14). For a cooperative association of producers

    that is acting for and owned or controlled by such associations, we

    believe that this conclusion applies to any swap between such

    cooperative association of producers and any cooperative association

    of producers that is a member of it, and any producer that is a

    member of any such cooperative association of producers that is

    itself a member of the first cooperative association of producers.

    See CFTC Regulation Sec. 1.3(ggg)(6)(ii)(C).

    However, we do not believe that this conclusion applies to any

    security-based swap that a cooperative association of producers may

    enter into, nor does it apply to any swap related to a non-physical

    commodity (such as a rate swap). For this reason, the exclusion for

    cooperative associations of producers is limited to swaps that are

    primarily based on a commodity that is not an excluded commodity.

    See CFTC Regulation Sec. 1.3(ggg)(6)(ii)(A)(3). The term ``excluded

    commodity'' is defined in CEA section 1a(19), 7 U.S.C. 1a(19).

    ---------------------------------------------------------------------------

    Accordingly, the final rules specifically provide that the dealer

    analysis excludes swaps between a cooperative and its members, so long

    as the swaps in question are reported to the relevant SDR by the

    cooperative and are subject to policies and procedures of the

    cooperative which ensure that it monitors and manages the risk of such

    swaps.\356\ The final rules define the term ``cooperative'' to include

    cooperative associations of producers and any entity chartered under

    Federal law as a cooperative and predominantly engaged in activities

    that are financial in nature.\357\ The cooperatives covered by this

    relief are subject to provisions of Federal law providing for their

    cooperative purpose. Cooperative associations of producers have been

    recognized since the passage of the Capper-Volstead Act as being

    permitted to engage in certain cooperative activities without violating

    antitrust laws.\358\ Cooperative financial institutions such as the

    Farm Credit System institutions and Federal Home Loan Banks are

    chartered under Federal laws that limit their membership and require

    that they serve certain public purposes.\359\

    ---------------------------------------------------------------------------

    \356\ See CFTC Regulation Sec. 1.3(ggg)(6)(ii). To be clear,

    these cooperatives are not excluded from the dealer definitions. See

    part II.A.6, supra. Rather, swaps between a cooperative and its

    members (and swaps that a cooperative enters into to hedge or lay

    off the risk of such swaps) are excluded from the dealer analysis.

    If a cooperative were to engage in other swap activities that are

    covered by, and not otherwise excluded from, the statutory

    definition of the term ``swap dealer,'' then it would be required to

    register as a swap dealer.

    \357\ See CFTC Regulation Sec. 1.3(ggg)(6)(ii)(B).

    \358\ See Capper-Volstead Act section 1, 7 U.S.C. 291.

    \359\ See Farm Credit Act of 1971, 12 U.S.C. 2001 et seq. and

    Federal Home Loan Bank Act, 12 U.S.C. 1421 et seq.

    ---------------------------------------------------------------------------

    We are aware that other persons commented that their swap

    activities should be excluded from the dealer analysis because they use

    swaps in connection with a cooperative or non-profit purpose, or

    because they aggregate demand for swaps arising from numerous small

    entities.\360\ However, the key distinction drawn in granting this

    relief is that cooperatives covered by the exclusion enter into swaps

    with their members in order to allocate risk between the members and

    [[Page 30626]]

    the cooperative. By contrast, the other entities noted above enter into

    swaps with unaffiliated parties in order to transfer risks between

    unaffiliated parties.\361\ As noted above, the Commissions believe that

    the contemplated scope of the statutory definitions does not include

    instances where a person's swap activities transfer risk within an

    affiliated group, but does extend to activities that create legal

    relationships that transfer risk between unaffiliated parties. Thus, it

    is appropriate that the dealer analysis exclude swaps between a

    cooperative and its members, but such analysis should include swaps

    between a cooperative or other aggregator and unaffiliated persons.

    ---------------------------------------------------------------------------

    \360\ See letter from NFPEEU (not-for-profit power utilities,

    electric cooperatives and related persons); letters from Farmers'

    Associations, NGFA I and NMPF (referring to private companies that

    serve as aggregators for swaps in agricultural commodities or

    otherwise offer swaps for agricultural risk management); and letter

    from Northland Energy (small energy firm that aggregates demand for

    swaps from small energy retailers and consumers).

    \361\ See, e.g., letter from NFPEEU (not-for-profit power

    utilities and electric cooperatives generally enter into swaps

    between themselves, with large industrial consumers, and a wide

    range of other counterparties). Indeed, the Dodd-Frank Act permits

    the CFTC to exempt agreements, contracts or transactions between

    entities described in section 201(f) of the Federal Power Act, such

    as certain not-for-profit power utilities and electric cooperatives.

    See section 722(f) of the Dodd-Frank Act. As noted above, a

    coalition of not-for-profit power utilities and electric

    cooperatives has advised that it plans to submit a request for the

    exemption contemplated by section 722(f) of the Dodd-Frank Act. See

    note 295 supra.

    ---------------------------------------------------------------------------

    D. De Minimis Exception

    1. Proposed Approach

    The Dodd-Frank Act's definitions of ``swap dealer'' and ``security-

    based swap dealer'' require that the Commissions exempt from dealer

    designation any entity ``that engages in a de minimis quantity'' of

    dealing ``in connection with transactions with or on behalf of

    customers.'' The statutory definitions further require the Commissions

    to ``promulgate regulations to establish factors with respect to the

    making of any determination to exempt.'' \362\

    ---------------------------------------------------------------------------

    \362\ CEA section 1a(49)(D), 7 U.S.C. 1a(49)(D); Exchange Act

    section 3(a)(71)(D), 15 U.S.C. 78c(a)(71)(D).

    ---------------------------------------------------------------------------

    In the Proposing Release, we preliminarily concluded that the de

    minimis exception ``should be interpreted to address amounts of dealing

    activity that are sufficiently small that they do not warrant

    registration to address concerns implicated by the regulations

    governing swap dealers and security-based swap dealers. In other words,

    the exception should apply only when an entity's dealing activity is so

    minimal that applying dealer regulations to the entity would not be

    warranted.'' \363\ In taking this view, we rejected the suggestion that

    the de minimis exception should compare a person's swap or security-

    based swap dealing activities to the person's non-dealing

    activities.\364\

    ---------------------------------------------------------------------------

    \363\ Proposing Release, 75 FR at 80179 (footnote omitted).

    \364\ See id. at 80179-80.

    ---------------------------------------------------------------------------

    At the same time, we recognized that this proposed approach did not

    appear to ``readily translate into objective criteria.'' We further

    recognized that a range of alternative approaches may be reasonable,

    and we solicited comment as to what factors should be used to implement

    the exception.\365\

    ---------------------------------------------------------------------------

    \365\ See id. at 80180.

    ---------------------------------------------------------------------------

    The proposed de minimis exception was comprised of three factors,

    all of which a person would have had to satisfy to avail itself of the

    exception.\366\ The first proposed factor would have limited the

    aggregate effective amount, measured on a gross basis, of the swaps or

    security-based swaps that a person entered into over the prior 12

    months in connection with its dealing activities to $100 million \367\

    (or $25 million with regard to counterparties that are ``special

    entities'').\368\

    ---------------------------------------------------------------------------

    \366\ Under the proposal, the factors would consider a person's

    swap or security-based swap dealing activity as a whole, rather than

    separately considering different types of swaps or security-based

    swaps. See Proposing Release, 75 FR at 80181.

    \367\ See proposed Exchange Act rule 3a71-2(a). The proposed

    standard reflected our understanding that in general the notional

    size of a small swap or security-based swap is $5 million or less,

    and that the proposed threshold would reflect 20 instruments of that

    size. The standard also sought to reflect the customer protection

    issues implicated by swaps and security-based swaps. See Proposing

    Release, 75 FR at 80180.

    The proposed notional threshold would not consider the market

    risk offsets associated with combining long and short positions. In

    addition, the proposed notional threshold would not account for the

    amount of collateral held or posted by the entity, or other risk

    mitigating factors. See id.

    \368\ See proposed Exchange Act rule 3a71-2(a). As set forth by

    the statutory business conduct rules applicable to security-based

    swap dealers (as set forth in Exchange Act section 15F(h)(2)(C)),

    ``special entity'' refers to: Federal agencies; States, State

    agencies and political subdivisions (including cities, counties and

    municipalities); ``employee benefit plans'' as defined under the

    Employee Retirement Income Security Act of 1974 (``ERISA'');

    ``governmental plans'' as defined under ERISA; and endowments. Title

    VII imposes additional business conduct requirements on security-

    based swap dealers in connection with special entities. See CEA

    sections 4s(h)(2), 4s(h)(4), 4s(h)(5); Exchange Act section

    15F(h)(2), (4), (5).

    ---------------------------------------------------------------------------

    The second proposed factor would have limited a person's swap or

    security-based swap dealing activity to no more than 15 counterparties

    over the prior 12 months (while counting counterparties that are

    members of an affiliated group as one counterparty for these purposes).

    The final proposed factor would have limited a person's dealing

    activity to no more than 20 swaps or security-based swaps over the

    prior 12 months (without counting certain amendments as new swaps or

    security-based swaps).

    2. Commenters' Views

    a. Basis for the Exception

    Some commenters sought to link the de minimis exception to systemic

    risk criteria by taking the position that a person should have to

    register as a dealer only if its dealing activities pose systemic

    significance.\369\ One commenter specifically objected to the position

    in the Proposing Release that the de minimis exception should take into

    account customer protection principles.\370\ On the other hand, one

    commenter supported the rejection of a risk-based de minimis test.\371\

    ---------------------------------------------------------------------------

    \369\ See, e.g., letters from CDEU, MFX II, NCGA/NGSA II and

    SIFMA--Regional Dealers Derivatives Committee (``SIFMA--Regional

    Dealers'').

    \370\ See letter from WGCEF I (arguing that basing the exception

    on customer protection principles would be contrary to the statutory

    framework, given that only ECPs are eligible to participate in off-

    exchange swap transactions).

    \371\ See letter from Better Markets I.

    ---------------------------------------------------------------------------

    Some commenters argued that the de minimis test should account for

    proportionality criteria that would excuse entities whose dealing

    activity is relatively minor compared to their other activities.\372\

    ---------------------------------------------------------------------------

    \372\ See, e.g., letters from FHLB I, IECA-Credit I, NCGA/NGSA

    I, NRG Energy, Peabody and WGCEF I. One commenter said the

    proportionality criteria should also consider an entity's activities

    with respect to the physical commodity underlying its swaps. See

    letter from NCGA/NGSA I. But see letter from Better Markets I

    (supporting rejection of a proportionality test). Some commenters

    suggested more than one alternative approach.

    ---------------------------------------------------------------------------

    b. Significance of ``Customer'' Language

    One commenter took the position that the language within the de

    minimis exception that specifically referred to ``transactions with or

    on behalf of customers'' meant that the exception should be available

    only for persons who limit their swaps or security-based swaps to those

    that are entered into with or on behalf of customers.\373\ Other

    commenters posited the opposite view that the ``customer'' language

    should be read to mean that a person's dealing activities with

    counterparties other than customers may be disregarded for purposes of

    the exception (i.e., non-customer transactions would not count against

    the de minimis thresholds).\374\ Some commenters argued that

    [[Page 30627]]

    transactions entered into in a fiduciary capacity should be disregarded

    for purposes of the exception.\375\ One commenter questioned the

    proposal's use of the term ``counterparty'' in lieu of the statutory

    term ``customer.'' \376\

    ---------------------------------------------------------------------------

    \373\ See letter from Better Markets I. Another commenter said

    that the ``customer'' language serves to emphasize that the de

    minimis exception is available to entities that provide swaps to

    customers. See letter from NGFA I.

    \374\ See letters from ISDA I, Vitol and WGCEF I. Another

    commenter said that the use of the term ``customer'' indicates that

    all transactions with physical commodity customers should be

    disregarded in determining if a person is a dealer. See letter from

    EDF Trading.

    \375\ See, e.g., letter from FSR I.

    \376\ See letter from Vitol (suggesting that the proposed

    language meant that dealing activity involved ``customers'' but not

    ``counterparties'').

    ---------------------------------------------------------------------------

    c. Proposed Tests and Thresholds

    Commenters criticized the proposed de minimis thresholds in a

    variety of ways. These included arguments that the proposed thresholds

    were inappropriately low,\377\ would harm end-users by reducing the

    number of entities willing to enter into low-value swaps and security-

    based swaps,\378\ would be unjustified on a cost-benefit basis,\379\

    and were disproportionately low compared to the activities of

    recognized dealers.\380\ Other commenters said the de minimis

    thresholds should be set at a level to allow entities to engage in a

    meaningful amount of customer-facing swaps or security-based swaps

    without being required to register as dealers.\381\

    ---------------------------------------------------------------------------

    \377\ See, e.g., letters from API I, CDEU, DFA, EDF Trading,

    Farm Credit Council I, Growmark, Land O'Lakes dated January 13, 2011

    (``Land O'Lakes I''), Midsize Banks, NCFC I, NCGA/NGSA II, New York

    City Bar Association--Committee on Futures and Derivatives

    Regulation (``NYCBA Committee''), Northland Energy, NRG Energy,

    Regional Banks and SIFMA--Regional Dealers. Some commenters also

    said that the thresholds, particularly those for swaps, should vary

    according to the riskiness of the swap or type of commodity

    underlying the swap. See letters from BG LNG I, Farm Credit Council

    I, Gavilon II, ISDA I, NFPEEU, Vitol and WGCEF I.

    \378\ See, e.g., letters from API I, BG LNG IFarm Credit Council

    I, Midsize Banks, NCFC I, NGFA I, Regional Banks and SIFMA--Regional

    Dealers and meetings with Electric Companies on April 13, 2011, the

    Asset Management Group of SIFMA (``SIFMA--AMG'') on February 4, 2011

    and WGCEF on April 28, 2011.

    \379\ See, e.g., letters from CDEU and Vitol. Another commenter

    noted that application of a cost-benefit analysis of the de minimis

    threshold could be challenging. See Roundtable Transcript at 193-94

    (remarks of Camille Rudge, The PrivateBank and Trust Company).

    \380\ See letter from CDEU (citing statistics indicating that

    the average respondent to an ISDA survey had an annual ``event

    volume'' of over 297,000 OTC derivatives trade processing actions);

    see also letter from Regional Banks.

    \381\ See meetings with Electric Companies on April 13, 2011,

    Gavilon on May 11, 2011 and WGCEF on April 28, 2011.

    ---------------------------------------------------------------------------

    A number of commenters particularly criticized the proposed

    notional threshold, with some commenters suggesting that the threshold

    should be based on a percentage of the total swap market \382\ or some

    other fixed value,\383\ or arguing in favor of an exposure-based

    threshold in lieu of a notional threshold.\384\ Other commenters said

    that the aggregate notional amount of swaps is not a meaningful measure

    of an entity's dealing activity.\385\ A few commenters supported the

    proposed notional threshold.\386\

    ---------------------------------------------------------------------------

    \382\ See letter from COPE I (suggesting 0.001% of the total

    U.S. swap market, amounting to approximately $3 billion); see also

    letters from API dated June 3, 2011 (``API II''), EDF Trading,

    Edison Int'l, EEI/EPSA, IECA-Credit I, NCGA/NGSA II, NextEra,

    NFPEEU, Utility Group and WGCEF I (suggesting 0.001% of the total

    U.S. swap market).

    \383\ See, e.g., meeting with Land O'Lakes on January 6, 2011

    (suggesting the threshold be increased by 2 to 5 times--i.e., to

    $200 million to $500 million); letters from Growmark, FHLB I and MFX

    II (each supporting $1 billion notional standard); Regional Banks

    (supporting $2 billion notional standard); letter from NCFC dated

    October 31, 2011 (``NCFC III'') (supporting alternative notional

    standards of $1 billion or $3 billion depending on certain

    assumptions); letter from FSR VI and joint letter from Capital One,

    Fifth Third Bancorp and Regions Financial Corporation (suggesting

    notional standard of at least $2 billion); letter from WGCEF dated

    June 3, 2011 regarding the swap dealer definition (``WGCEF V'')

    (suggesting notional standard of $3.5 billion); and letter from IPR-

    GDF Suez Energy North America (suggesting notional standard of $10

    billion). Some commenters suggested more than one possible

    threshold.

    \384\ See, e.g., letters from Farm Credit Council I, FSR VI and

    Midsize Banks. Other commenters said the threshold should account

    for the effect of netting. See letters from API II, Chesapeake

    Energy, Land O'Lakes I and MFX II. On the other hand, one commenter

    specifically supported the use of the gross notional amount. See

    letter from Greenberger.

    \385\ See letters from Farm Credit Council I, ISDA I, Land

    O'Lakes I, Midsize Banks, NCFC I, SIFMA--Regional Dealers and Vitol.

    \386\ See letters from AFR, Better Markets I, Greenberger and

    NMPF. One of these commenters said that data on credit default swaps

    analyzed by the SEC's Division of Risk, Strategy, and Financial

    Innovation indicates that the $100 million proposed notional

    thresholds are too high. See letters from Better Markets to CFTC and

    SEC dated April 6, 2012 (``Better Markets III'').

    ---------------------------------------------------------------------------

    Some commenters argued against basing the de minimis exception on

    the number of a person's swaps or security-based swaps or the number of

    a person's counterparties,\387\ or supported increasing those

    thresholds above the proposed standard.\388\ Commenters also suggested

    a variety of other alternatives to the proposed tests.\389\

    ---------------------------------------------------------------------------

    \387\ See, e.g., letters from API II, Atmos Energy, Chesapeake

    Energy, COPE I, EEI/EPSA, Gavilon II, IECA-Credit I, Land O'Lakes I,

    NCGA/NGSA II, NEM, NextEra I, NMPF, NRG Energy, Peabody and Utility

    Group.

    \388\ See, e.g., letters from ISDA I (suggesting 25 transactions

    over 12 months); FHLB I (suggesting 25 counterparties and 50

    transactions over 12 months) FSR I and Midsize Banks (each

    suggesting 75 counterparties and 200 transactions over 12 months);

    Regional Banks (suggesting 100 counterparties and 300 transactions

    over 12 months); Growmark and MFX II (suggesting thresholds should

    be increased by a factor of 10) and meeting with Land O'Lakes on

    January 6, 2011 (suggesting thresholds should be increased by a

    factor of between 2 and 5).

    One commenter said the number of transaction and number of

    counterparty standards should be disjunctive--i.e., a dealer's

    activity would be de minimis if it were below either standard. See

    letter from Northland Energy. Other commenters raised questions

    about how counterparties or transactions should be counted for

    purposes of the standard. See letters from CDEU (novations should

    not be counted as new transactions) and J.P. Morgan (members of an

    affiliated group should be counted as one counterparty), joint

    letter from BB&T, East West Bank, Fifth Third Bank, The PrivateBank

    and Trust Company, Regions Bank, Sun Trust Bank, U.S. Bank National

    Association and Wells Fargo Bank, N.A. (``Midmarket Banks'')

    (questioning how to count multiple borrower counterparties to a loan

    and swap) and meeting with Land O'Lakes on January 6, 2011 (members

    of a cooperative should be counted as one counterparty).

    Last, some commenters said that the number of transaction or

    number of counterparty standards should be deleted because they are

    not useful as tests of de minimis status. See letters from Gavilon

    II (eliminate both standards) and SIFMA--Regional Dealers (eliminate

    number of counterparties standard).

    \389\ See letters from IECA-Credit I (suggesting that exception

    exclude persons whose positions either are below a notional

    threshold or are below a combined proportionality and revenue

    threshold), SIFMA--Regional Dealers (supporting annual threshold of

    500 customer-facing or riskless principal swaps, consistent with the

    de minimis exception from the Exchange Act ``broker'' definition in

    connection with bank brokerage activity, as well as SEC rules in

    connection with the Exchange Act definition of ``dealer''), FHLB I

    (supporting non-quantitative test accounting for relatively small

    swap-related exposure compared to primary customer activity,

    collateral that also provides credit support for other business done

    with the customer, an existing relationship with customer and

    inability of customer to obtain swaps from entities that primarily

    are dealers), Gavilon II (alluding to use of non-quantitative

    tests), MFX II (suggesting establishment of a separate qualitative

    process by which a dealer may establish why registration is not

    warranted) and DC Energy (thresholds should be set at a level

    appropriate to support the capital levels to be required for swap

    dealers).

    ---------------------------------------------------------------------------

    d. Additional Issues

    Some commenters emphasized the need to provide protections in

    connection with ``special entities.'' \390\ Certain commenters sought

    to identify problems related to the application of the proposed

    thresholds in connection with particular types of businesses or

    markets,\391\ or to aggregators or

    [[Page 30628]]

    cooperatives.\392\ Other commenters suggested that the exception should

    focus dealer regulation toward ``financial'' entities.\393\ One

    commenter emphasized the need for the exception to be available when

    the end-user is a credit union, bank or thrift.\394\

    ---------------------------------------------------------------------------

    \390\ See letters from Better Markets I (arguing that the de

    minimis exception should not be available in connection with

    transactions with special entities), AFR (similar), Greenberger

    (supporting reduction of the notional threshold for transactions

    with special entities to $5 million) and AFSCME. Some commenters

    said the standard for swaps and security-based swaps with special

    entities should be a notional value equal to 0.0001% of the total

    U.S. swap market. See letters from COPE I, EDF Trading, EEI/EPSA,

    IECA-Credit I, NFPEEU and Utility Group. One commenter said the

    threshold for special entities should be eliminated because it is

    not useful in determining de minimis status. See letter from Gavilon

    II.

    \391\ See letters from BG LNG I (small energy companies), COPE I

    and Northland Energy (each discussing commodity markets, suggesting

    that notional thresholds be based on the unit of a commodity), NCFC

    I (commodity prices), NGFA I (grain elevators) and WGCEF I (energy

    prices).

    \392\ See, e.g., letters from Growmark and Land O'Lakes I.

    \393\ See letters from NEM, NextEra I, and NGFA I.

    \394\ See letter from CUNA.

    ---------------------------------------------------------------------------

    Commenters sought clarification that the de minimis criteria would

    not apply to transactions for hedging or proprietary trading

    purposes,\395\ or to inter-affiliate transactions.\396\

    ---------------------------------------------------------------------------

    \395\ See, e.g., letters from API I, EDF Trading, Gavilon II and

    SIFMA--Regional Dealers.

    \396\ See, e.g., letter from Atmos Energy Holdings, Inc (``Atmos

    Holdings'').

    ---------------------------------------------------------------------------

    Commenters also raised issues related to the exception's treatment

    of the proposed use of a rolling annual period for calculations,\397\

    the proposed use of ``effective notional amounts,'' \398\ the

    possibility of adjusting the thresholds over time,\399\ how the de

    minimis tests would apply in the context of affiliated positions,\400\

    and how the exception would account for swaps or security-based swaps

    entered into before the definition's effective date.\401\

    ---------------------------------------------------------------------------

    \397\ See letters from NCGA/NGSA I (supporting measurement of

    rolling period average over 12 months), NextEra I (supporting

    evaluation as of the last day of each calendar quarter rather than

    over the immediate preceding 12 months) and Northland Energy

    (requesting clarification that if a monetary notional amount is

    used, the evaluation periods should be fixed rather than rolling).

    \398\ See letters from ISDA I (stating that the use of

    ``effective notional amount'' in the test introduces ambiguity and

    uncertainty) and WGCEF I (notional amounts should be measured on a

    ``delta-equivalent'' basis).

    \399\ See letters from Farm Credit Council I (supporting

    automatic periodic increases to reflect changes in market size, the

    size of typical contracts and inflation), Greenberger (supporting

    reevaluation of the de minimis criteria on an ongoing basis), and BG

    LNG I, EEI/EPSA, NCFC I and WGCEF I (each supporting inflation or

    market size adjustments).

    \400\ See meeting with Edison Int'l (requesting clarification

    that an entity that is prohibited from coordinating its financial

    derivatives activities should determine whether it qualifies for the

    de minimis exception without considering financial derivatives

    entered into by its affiliated entities).

    \401\ See letter from Covington & Burling (urging clarification

    that lookback period will not commence until all the relevant

    regulations become effective).

    ---------------------------------------------------------------------------

    Some commenters suggested that the de minimis thresholds be set

    higher initially to provide for efficient use of regulatory

    resources.\402\ One commenter requested clarification that the

    exception would apply prospectively without regard to dealing

    activities taken prior to the effectiveness of Title VII.\403\ One

    commenter requested that a person that falls above the de minimis tests

    be able to take advantage of application and re-evaluation periods akin

    to those associated with the major participant definitions.\404\

    ---------------------------------------------------------------------------

    \402\ See letters from BGLNG I and WGCEF V. See also Roundtable

    Transcript at 50-51 (remarks of Ron Oppenheimer, WGCEF), 57 (remarks

    of Richard Ostrander, Morgan Stanley) and 208-09 (remarks of Bella

    Sanevich, NISA Investment Advisors).

    \403\ See letter from FSR I.

    \404\ See letter from WGCEF I; see also Northland Energy

    (supporting grace period for registration if the de minimis

    threshold is exceeded).

    ---------------------------------------------------------------------------

    Two commenters expressed support for the proposed self-executing

    approach of the exception.\405\ Some commenters requested clarification

    that the de minimis exception is independent of the loan origination

    exclusion in the CEA ``swap dealer'' definition.\406\

    ---------------------------------------------------------------------------

    \405\ See letters from ISDA I and Northland Energy.

    \406\ See letters from FSR VI and Midsize Banks.

    ---------------------------------------------------------------------------

    A number of commenters also addressed the application of dealer

    regulation to non-U.S. entities. While those comments did not

    specifically address the de minimis exception, the exception may be

    relevant to addressing these cross-border issues.\407\

    ---------------------------------------------------------------------------

    \407\ Some commenters particularly took the view that the

    application of the dealer definitions to non-U.S. persons should

    solely address those persons' U.S. dealing activities. See letters

    from FSR I, ISDA I and Soci[eacute]t[eacute] G[eacute]n[eacute]rale.

    Some commenters also specifically identified concerns of

    international comity in this context. See letters cited in note 148,

    supra.

    The Commissions intend to address the application of dealer

    regulation to non-U.S. persons as part of separate releases that

    generally will address the application of Title VII to non-U.S.

    persons.

    ---------------------------------------------------------------------------

    One commenter separately addressed the credit default swap data

    analysis made available by CFTC and SEC staffs.\408\ The commenter

    expressed the view that this data supported the adoption of a de

    minimis threshold of $100 million or less, particularly focusing on the

    number of entities that may be excluded under particular

    thresholds.\409\

    ---------------------------------------------------------------------------

    \408\ See letter from Better Markets III.

    \409\ See id.

    ---------------------------------------------------------------------------

    3. Final Rules--General Principles for Implementing the De Minimis

    Exception

    a. Balancing Regulatory Goals and Burdens

    The Commissions recognize that implementing the de minimis

    exception requires a careful balancing that considers the regulatory

    interests that could be undermined by an unduly broad exception as well

    as those regulatory interests that may be promoted by an appropriately

    limited exception.

    On the one hand, a de minimis exception, by its nature, will

    eliminate key counterparty protections provided by Title VII for

    particular users of swaps and security-based swaps.\410\ The broader

    the exception, the greater the loss of protection.\411\ Moreover, in

    determining the scope of the exception, it is important to consider not

    only the current state of the swap and security-based swap markets, but

    also to account for how those markets may evolve in the future. This is

    particularly important because the full implementation of Title VII--

    including enhancements to pricing transparency and the increased access

    to central clearing--reasonably may be expected to facilitate new

    entrants into the swap and security-based swap markets. To the extent

    that such entrants engage in dealing activity below the de minimis

    threshold--either for the long term or until their activity surpasses

    the threshold--the relative amount of unregistered activity within the

    market may be expected to increase. Accordingly, a higher de minimis

    threshold may not only result in a certain percentage of unregistered

    activity being transacted initially, consistent with the current

    market, but also may result in an even greater proportion of

    unregistered activity being transacted in the future.

    ---------------------------------------------------------------------------

    \410\ A number of commenters expressed particular concerns as to

    the threats that an overbroad exception would pose to special

    entities. See letters from AFR (noting that Congress incorporated

    special protections for special entities in reaction to news reports

    about special entities losing millions of dollars ``after signing up

    for derivatives deals they did not understand,'' and urging the

    elimination of any de minimis exception for transactions with

    special entities); Better Markets I (stating that history has shown

    that special entities are vulnerable to abuse, and that they need

    capital, collateral and business conduct protections as much as or

    more than any other category of market participants); and AFSCME

    (expressing skepticism as to the view that dealer status would

    preclude firms from entering into transactions with special

    entities). Some of those commenters also generally supported the

    proposed $100 million de minimis threshold. See letters from AFR and

    Better Markets I; see also letter from Greenberger (stating that the

    dynamic nature of the derivatives sector of the financial markets

    should counsel caution, and that the de minimis threshold should be

    reevaluated on an ongoing basis).

    \411\ Notwithstanding the reduction in protection, however, in

    the case of swaps and security-based swaps the general antifraud

    provisions of the CEA and the securities laws, respectively,

    including rules to be adopted by the SEC pertaining specifically to

    security-based swaps, will continue to apply to all transactions in

    security-based swaps. See, e.g., CEA section 4b(2), 7 U.S.C. 6b(2).

    ---------------------------------------------------------------------------

    On the other hand, the Commissions also recognize that Congress

    included a statutorily mandated de minimis exception for certain swap

    and security-based swap dealing activity, and that an appropriately

    calibrated de minimis exception has the potential to advance other

    interests. For example, the de minimis exception may further the

    interest of regulatory efficiency when

    [[Page 30629]]

    the amount of a person's dealing activity is, in the context of the

    relevant market, limited to an amount that does not warrant

    registration to address the concerns implicated by government

    regulation of swap dealers and security-based swap dealers. To advance

    this interest, it is necessary to consider the benefits to the

    marketplace associated with the regulation of dealers against the total

    burdens and potential impacts on competition, capital formation and

    efficiency associated with that regulation.\412\

    ---------------------------------------------------------------------------

    \412\ While we are mindful that the Commissions have yet to

    adopt all the final substantive rules applicable to swap dealers and

    security-based swap dealers, we nonetheless believe that we have

    sufficient understanding of those potential requirements to

    reasonably balance the relevant factors to identify the initial

    level of dealing activity that should be considered to be de

    minimis. Moreover, finalizing the dealer definitions will help

    provide for the orderly and informed finalization of those other

    substantive rules governing swap dealers and security-based swap

    dealers.

    ---------------------------------------------------------------------------

    In addition, the exception can provide an objective test for

    persons who engage in some swap or security-based swap activities that,

    in their view, potentially raise the risk that they would be deemed to

    be dealers.\413\ The exception also may permit persons that are not

    registered as dealers to accommodate existing clients that have a need

    for swaps or security-based swaps in conjunction with other financial

    services or commercial activities, thus avoiding the need for such

    clients to establish separate relationships with registered dealers,

    which may have attendant costs. The exception further may promote

    competition in dealing activity within the swap or security-based swap

    markets, by helping to allow non-registered persons to commence

    providing dealing services while avoiding the costs associated with

    full-fledged dealers. More competition within the market for swaps and

    security-based swaps may not only decrease the costs for participants

    in the market, but also may help to decrease systemic risk by lessening

    the current apparent concentration of dealing activity among a few

    major market participants.\414\

    ---------------------------------------------------------------------------

    \413\ ``Congress incorporated a de minimis exception to the Swap

    Dealer definition to ensure that smaller institutions that are

    responsibly managing their commercial risk are not inadvertently

    pulled into additional regulation.'' See 156 Cong. Rec. S6192 (daily

    ed. July 22, 2010) (letter from Senators Dodd and Lincoln to

    Representatives Frank and Peterson).

    \414\ See 478 through 487 and accompanying text, infra.

    ---------------------------------------------------------------------------

    The statutory requirements that apply to swap dealers and security-

    based swap dealers include requirements aimed at the protection of

    customers and counterparties,\415\ as discussed above, as well as

    requirements aimed at helping to promote effective operation and

    transparency of the swap and security-based swap markets.\416\ The

    overall economic benefits provided by these requirements in large part

    will depend on the proportion of swaps and security-based swaps that

    are transacted subject to these requirements. In other words, the

    greater the dealing activity of a registered dealer, the more

    significant the resulting increase in market efficiency,\417\ and the

    greater the reduction in risks faced by the entity's customers and

    counterparties.\418\ These benefits can be expected to accrue over the

    long term and be distributed over the market and its participants as a

    whole. This is not to say, however, that it would be insignificant for

    any particular counterparty if its swaps or security-based swaps were

    to fall outside of the ambit of dealer regulation. For example, a

    customer or counterparty that is not protected by the business conduct

    rules applicable to dealers might be more likely to suffer losses

    associated with entering into an inappropriate or misunderstood swap or

    security-based swap than if the instrument was transacted pursuant to

    the business conduct rules applicable to registered dealers.

    ---------------------------------------------------------------------------

    \415\ As discussed above, in part, these customer and

    counterparty protections derive from the financial responsibility

    requirements applicable to dealers, particularly: capital and margin

    requirements (CEA section 4s(e); Exchange Act section 15F(e)), and

    requirements for segregation of collateral (CEA sections 4d(f),

    4s(l); Exchange Act section 3E).

    These customer and counterparty protections also derive from

    certain other requirements applicable to dealers, particularly:

    requirements with respect to business conduct when transacting with

    special entities (CEA sections 4s(h)(2), 4s(h)(4), 4s(h)(5);

    Exchange Act sections 15F(h)(2), (h)(4), (h)(5)); disclosure

    requirements (CEA section 4s(h)(3)(B); Exchange Act section

    15F(h)(3)(B)); requirements for fair and balanced communications

    (CEA section 4s(h)(3)(D); Exchange Act section 15F(h)(3)(C)); other

    requirements related to the public interest and investor protection

    (CEA section 4s(h)(3)(D); Exchange Act section 15F(h)(3)(D)); and

    conflict of interest provisions (CEA section 4s(j)(5); Exchange Act

    section 15F(j)(5)).

    \416\ Relevant provisions are: reporting and recordkeeping

    requirements (CEA section 4s(f); Exchange Act section 15F(f)); daily

    trading records requirements (CEA section 4s(g); Exchange Act

    section 15F(g)); regulatory standards related to the confirmation,

    processing, netting, documentation and valuation of security-based

    swaps (CEA section 4s(i); Exchange Act section 15F(i)); position

    limit monitoring requirements (CEA section 4s(j)(1); Exchange Act

    section 15F(j)(1)); risk management procedure requirements (CEA

    section 4s(j)(2); Exchange Act section 15F(j)(2)); and requirements

    related to the disclosure of information to regulators (CEA section

    4s(j)(3); Exchange Act section 15F(j)(3)).

    \417\ For example, the more swaps or security-based swaps a

    dealer enters into, the more significant will be the efficiency

    benefits associated with confirmation, processing, netting

    documentation and valuation requirements applicable to dealers.

    \418\ For example, the more swaps or security-based swaps a

    dealer enters into, the more significant the number of

    counterparties that will be protected by the disclosure and other

    business conduct obligations imposed on dealers.

    ---------------------------------------------------------------------------

    In contrast to the benefits associated with dealer regulation, many

    of the burdens of dealer regulation will accrue in the short term and

    will fall directly on registered dealers.\419\ Some of those burdens

    may be expected to be independent of the amount of an entity's dealing

    activity (i.e., entities that engage in minimal dealing activity would

    still be expected to face certain burdens associated with the

    registration process and the development of compliance and other

    systems if they are required to register as dealers), while other

    burdens (e.g., the impact of margin and capital rules applicable to

    dealers) may be more directly linked to the amount of that entity's

    dealing activity.

    ---------------------------------------------------------------------------

    \419\ Certain commenters also have expressed concerns that the

    prospect of regulation may deter certain entities from engaging in

    limited swap or security-based swap dealing activities, see, e.g.,

    letters from SIFMA--Regional Dealers and Midsize Banks, which could

    reduce the availability of those instruments.

    ---------------------------------------------------------------------------

    As discussed below, the Commissions have sought to balance the

    various interests associated with a de minimis exception, as well as

    the benefits and burdens associated with such an exception, in

    developing the factors to implement the de minimis exceptions to the

    ``swap dealer'' and ``security-based swap dealer'' definitions.

    However, in moving forward with implementing this balancing

    approach, we recognize that the information that currently is available

    regarding certain portions of the swap market is limited. Following the

    full implementation of Title VII, more information will be available to

    permit us to assess the effectiveness of this balancing for particular

    markets and to revise the exception as appropriate.

    In that context--and in light of the tools currently available to

    us--we have been influenced, in particular, by comments taking the view

    that the de minimis factors should take into account the size and

    unique attributes of the market for swaps and security-based

    swaps.\420\ We believe that factors that exclude entities whose dealing

    activity is sufficiently modest in light of the total size,

    concentration and other attributes of the applicable markets can be

    useful in avoiding the imposition of

    [[Page 30630]]

    regulatory burdens on those entities for which dealer regulation would

    not be expected to contribute significantly to advancing the customer

    protection, market efficiency and transparency objectives of dealer

    regulation. The Commissions note, however, that they are not of the

    general view that the costs of extending regulation to any particular

    entity must be outweighed by the quantifiable or other benefits to be

    achieved with respect to that particular entity. The Commissions,

    rather, analyze the overall benefits and costs of regulation, keeping

    in mind, as noted above, that the benefits may be distributed, accrue

    over the long-term, and be difficult to quantify or to measure as

    easily as certain costs.\421\

    ---------------------------------------------------------------------------

    \420\ See, e.g., letters from CDEU (comparing proposed

    thresholds with statistics regarding the activities of recognized

    dealers) and EEI/EPSA (recommending that thresholds be set at an

    amount equal to 0.001 percent of the aggregate size of the U.S.

    swaps market, and 0.0001 percent for swaps in which the counterparty

    is a special entity).

    \421\ For example, it does not appear possible to demonstrate

    empirically--let alone quantify--the increase or decrease in the

    possibility that a financial crisis would occur at a particular

    future time and with a particular intensity in the absence of

    financial regulation or as a result of varying levels or types of

    financial regulation. It also is difficult to demonstrate

    empirically that the customer protections associated with dealer

    regulation would increase or decrease the likelihood that any

    particular market participant would suffer injury (or the degree to

    which the participant would suffer injury) associated with entering

    into an inappropriate swap or security-based swap. At the same time,

    certain costs may also not be readily susceptible to quantification

    or measurement, for example, the costs that might be associated with

    diminished presence, if any, of new entrants. The inability to

    quantify these benefits and costs does not mean that the benefits

    and costs of dealer regulation are any less substantial.

    ---------------------------------------------------------------------------

    b. Specific Factors Implementing the De Minimis Exception

    i. Notional Test

    Consistent with the proposal, the final rules implementing the de

    minimis exception take into account the notional amount of an entity's

    swap or security-based swap positions over the prior 12 months arising

    from its dealing activity.\422\ While the Commissions recognize that

    notional amounts do not directly measure the exposure or risk

    associated with a swap or security-based swap position, such measures

    do reflect the relative amount of an entity's dealing activity.\423\

    Moreover, although some commenters have posited measures of risk or

    exposure as alternatives to notional measures, such risk or exposure

    measures could, to the extent they allow for netting or collateral

    offsets, potentially allow an unregistered entity to engage in large

    amounts of swap or security-based swap dealing activity while remaining

    within the de minimis exception so long as that entity nets or

    collateralizes its swap or security-based swap positions. Such an

    outcome could undermine the customer protection and market operation

    benefits associated with dealer regulation. As with the proposed rules,

    the notional factor in the final rules is based on the notional

    positions of an entity over a 12 month period, rather than capping the

    current notional amount of a position at any time, to better reflect

    the amount of an entity's current activity.

    ---------------------------------------------------------------------------

    \422\ See CFTC Regulation Sec. 1.3(ggg)(4); Exchange Act rule

    3a71-2(a)(1). Over the first year following the effective date of

    the final rules implementing the statutory definition of ``swap''

    and ``security-based swap'' as set forth in CEA section 1a(47) and

    Exchange Act section 3(a)(68), respectively, this notional test will

    be based on the person's dealing activity following that effective

    date. See id. Accordingly, the analysis of whether a person may take

    advantage of the de minimis exception will not encompass the

    person's dealing activity prior to that effective date, given the

    need for the person to know whether an instrument is a swap or

    security-based swap for purposes of the analysis.

    \423\ ``Changes in notional volumes are generally reasonable

    reflections of business activity, and therefore can provide insight

    into potential revenue and operational issues. However, the notional

    amount of derivatives contracts does not provide a useful measure of

    either market or credit risks.'' OCC Quarterly Report at 8.

    ---------------------------------------------------------------------------

    The final rules, like the proposed rules, include lower notional

    thresholds for dealing activities in which the counterparty is a

    ``special entity.'' \424\ This is consistent with the fact that Title

    VII's requirements applicable to swap dealers and security-based swap

    dealers provide heightened protection to those types of entities.\425\

    It is important that the de minimis exception not undermine those

    statutory protections.\426\ Also, consistent with the Proposing

    Release, these notional standards will be based on ``effective

    notional'' amounts when the stated notional amount is leveraged or

    enhanced by the structure of the swap or security-based swap.\427\

    ---------------------------------------------------------------------------

    \424\ For these purposes, ``special entity'' means: (i) A

    Federal agency; (ii) a state, state agency, city, county,

    municipality, or other political subdivision of a state; (iii) any

    employee benefit plan, as defined in section 3 of the Employee

    Retirement Income Security Act of 1974 (``ERISA''); (iv) any

    governmental plan, as defined in section 3 of ERISA; or (v) any

    endowment, including an endowment that is an organization described

    in section 501(c)(3) of the Internal Revenue Code of 1986. See CEA

    section 4s(h)(2)(C) and CFTC Regulation Sec. 23.401(c); Exchange

    Act section 15F(h)(2)(C).

    \425\ See CEA sections 4s(h)(2), (4), (5); see also CFTC,

    Business Conduct Standards for Swap Dealers and Major Swap

    Participants with Counterparties; Final Rule, 77 FR 9733 (Feb. 17,

    2012); Exchange Act sections 15F(h)(2), (4), (5) (providing

    additional requirements for dealers that advise special entities or

    that enter into swaps or security-based swaps with special

    entities).

    \426\ The importance of the statutory protections for special

    entities has been highlighted by the SEC's recent action in

    connection with the inappropriate sale of notes linked to the

    performance of synthetic collateralized debt obligations to a number

    of school districts. According to a complaint filed in federal

    district court, these securities were unsuitable for the investment

    needs of the school districts, were sold to school districts that

    lacked the requisite sophistication and experience to independently

    evaluate the risks of the investment, and exposed the school

    districts to a heightened risk of catastrophic loss ultimately led

    to a complete loss of their investments. ``SEC Charges Stifel,

    Nicolaus and Former Executive with Fraud in Sale of Investments to

    Wisconsin School Districts,'' SEC Litigation Release No. 22064 (Aug.

    10, 2011) (http://www.sec.gov/litigation/litreleases/2011/lr22064.htm).

    \427\ For example, if an exchange of payments associated with a

    $1 million notional equity swap was based on three times the return

    associated with the underlying equity, the effective notional amount

    of the equity swap would be $3 million.

    ---------------------------------------------------------------------------

    ii. Other Tests From the Proposing Release

    The proposed rules limited the number of swaps or security-based

    swaps that an entity could enter into in a dealing capacity, and the

    number of an entity's counterparties in a dealing capacity. The final

    rules do not include those measures. In part, this reflects commenter

    concerns that a standard based on the number of swaps or security-based

    swaps or counterparties can produce arbitrary results by giving

    disproportionate weight to a series of smaller transactions or

    counterparties.\428\

    ---------------------------------------------------------------------------

    \428\ See, e.g., letter from COPE I.

    ---------------------------------------------------------------------------

    c. Significance of Statutory ``Customer'' Language

    Consistent with the Proposing Release, the final rules implementing

    the de minimis exception do not require the presence of any type of

    defined ``customer'' relationship.

    In adopting these rules the Commissions have considered alternative

    approaches suggested by commenters, including one commenter's

    suggestion that the de minimis exception should be available only in

    connection with swaps or security-based swaps entered into as part of a

    ``customer'' relationship.\429\ In considering that alternative view,

    however, we believe that it is significant that the statutory exception

    lacks terminology such as ``existing'' or ``preexisting'' that limits

    the availability of the exception or otherwise to distinguishes a

    ``customer'' relationship from other types of counterparty

    relationship. Also, while that alternative view could still permit an

    unregistered person to provide limited dealer services as an

    accommodation to an existing customer or counterparty, an

    interpretation that predicates the exception on the presence of a

    particular type of ``customer'' relationship would not advance other

    potential benefits associated with a de minimis exception, including

    the

    [[Page 30631]]

    benefit of providing certainty in connection with the swap or security-

    based swap activities of end-users.\430\ Accordingly, we do not believe

    that the ``customer'' reference standing alone provides a sufficient

    basis to conclude that the exception should only be available if there

    is an existing relationship of some type, and the final rules neither

    require that a dealer accommodate the demand of an existing customer

    nor require the presence of a preexisting relationship for the

    exception to apply.

    ---------------------------------------------------------------------------

    \429\ See letter from Better Markets I.

    \430\ As discussed above, see note 413, supra, there is

    legislative history that suggests that an intended purpose of the

    exception would be to ensure that the dealer definition does not

    encompass ``smaller institutions that are responsibly managing their

    commercial risk.''

    ---------------------------------------------------------------------------

    We also are not persuaded by the different commenter suggestion

    that the statutory de minimis exception's ``customer'' language means

    that an unregistered dealer should be permitted to engage in unlimited

    dealing activity so long as its counterparties are not customers.\431\

    Such an unlimited exception would appear to be contrary to the express

    language of the statutory exception. In addition, such an approach

    would lead to the perverse result of discouraging entities from

    entering into swaps or security-based swaps to facilitate risk

    management activities of customers (while encouraging other dealing

    activities), which appears contrary to Title VII's general approach of

    seeking to limit undue impacts on the swap and security-based swap

    activities of commercial end-users.

    ---------------------------------------------------------------------------

    \431\ See, e.g., letter from ISDA I.

    ---------------------------------------------------------------------------

    d. Focus on ``Dealing'' Activity

    Some commenters suggested that we clarify that the limitations

    associated with the de minimis exception apply only in connection with

    a person's dealing activities, and not to the person's hedging or

    proprietary trading activities.\432\ The Commissions agree that the de

    minimis exception is intended to permit an unregistered person to

    engage in a limited amount of dealing activity without regard to the

    person's non-dealing activity. Thus, to the extent that a particular

    swap or security-based swap position is not connected to dealing

    activity under the applicable interpretation of the statutory dealer

    definition, it will not count against the de minimis thresholds.

    Conversely, if a swap or security-based swap position is connected to

    the person's dealing activity, the position will count against those

    thresholds.\433\

    ---------------------------------------------------------------------------

    \432\ See, e.g., letters from SIFMA--Regional Dealers and EDF

    Trading.

    \433\ For purposes of the de minimis exception to the security-

    based swap dealer definition, we note that one indicator of dealing

    activity under the dealer-trader distinction is that a person profit

    by providing liquidity in connection with security-based swaps.

    Accordingly, for purposes of the de minimis exception to the

    security-based swap dealer definition, a security-based swap

    position that hedges or otherwise offsets a position that was

    entered into as part of dealing activity would itself comprise part

    of the person's dealing activity, and hence count against the de

    minimis thresholds.

    For purposes of the de minimis exception to the swap dealer

    definition, we take the view that the relevant question in

    determining whether swaps count as dealing activity against the de

    minimis thresholds is whether the swaps fall within the swap dealer

    definition under the statute and the final rules, as further

    interpreted by this Adopting Release. If hedging or proprietary

    trading activities did not fall within the definition, including

    because of the application of CFTC Regulation Sec. 1.3(ggg)(6),

    they would not count against the de minimis thresholds.

    ---------------------------------------------------------------------------

    Commenters also requested clarification that the de minimis

    thresholds do not apply to a person's inter-affiliate swaps and

    security-based swaps, nor apply to swaps covered by the exclusion for

    swaps entered into by insured depository institutions in connection

    with the origination of loans to customers.\434\ Consistent with the

    discussion above,\435\ such swaps or security-based swaps do not

    constitute dealing activity and should not be counted against the de

    minimis thresholds. Similarly, swaps between a cooperative and its

    members, as provided in CFTC Regulation Sec. 1.3(ggg)(6)(ii), and

    swaps entered into for the hedging purpose defined in CFTC Regulation

    Sec. 1.3(ggg)(6)(iii) should not be counted against the de minimis

    threshold.\436\

    ---------------------------------------------------------------------------

    \434\ See, e.g., letters from Atmos Holdings and FSR I.

    \435\ See parts II.B and II.C, supra.

    \436\ Swaps and security-based swaps that hedge, mitigate, or

    offset the types of swaps and security-based swaps discussed in the

    foregoing paragraph, which do not constitute dealing activity,

    similarly should not be counted against the de minimis thresholds.

    ---------------------------------------------------------------------------

    In light of the increased notional thresholds of the final rules,

    and the resulting opportunity for a person to evasively engage in large

    amounts of dealing activity if it can multiply those thresholds, the

    final rules provide that the notional thresholds to the de minimis

    exception encompass swap and security-based swap dealing positions

    entered into by an affiliate controlling, controlled by or under common

    control with the person at issue.\437\ This is necessary to prevent

    persons from avoiding dealer regulation by dividing up dealing activity

    in excess of the notional thresholds among multiple affiliates.\438\

    ---------------------------------------------------------------------------

    \437\ See CFTC Regulation Sec. 1.3(ggg)(4)(i); Exchange Act

    rule 3a71-2(a)(1). For these purposes, we interpret control to mean

    the possession, direct or indirect, of the power to direct or cause

    the direction of the management and policies of a person, whether

    through the ownership of voting securities, by contract or

    otherwise. This is consistent with the definition of ``control'' and

    ``affiliate'' in connection with Exchange Act rules regarding

    registration statements. See Exchange Act rule 12b-2.

    The final rules use a control standard in connection with the

    de minimis notional thresholds as a means reasonably designed to

    prevent evasion of the limitations of that exception. This contrasts

    with the majority-ownership standard used by the inter-affiliate

    exclusions from the dealer and major participant definitions. See

    parts II.C.2 and IV.G.2, infra. That majority-ownership standard,

    which in application will not be expected to be satisfied in all

    circumstances in which a control standard is satisfied, is

    reasonably designed to reflect the economic alignment that

    appropriately underpins those exclusions.

    \438\ In other words, for example, if a parent entity controls

    two subsidiaries which both engage in activities that would cause

    the subsidiaries to be covered by the dealer definitions, then each

    subsidiary must aggregate the swaps or security-based swaps that

    result from both subsidiaries' dealing activities in determining if

    either subsidiary qualifies for the de minimis exception.

    The SEC expects to address the application of this principle to

    the security-based swap activities of non-U.S. persons in a separate

    release.

    ---------------------------------------------------------------------------

    e. Alternative Approaches We Are Not Following

    Certain commenters have suggested alternative approaches to

    implementing the de minimis exception. While the Commissions have

    considered those suggested alternatives, we do not believe that they

    provide the optimal framework for implementing the exception.

    For example, some commenters took the position that the de minimis

    exception should focus dealer regulation on those entities whose

    dealing activities pose systemic risk, and excuse other dealers from

    having to register.\439\ Such an approach, however, would fail to

    account for regulatory interests apart from the control of systemic

    risk that are addressed by dealer regulation, including statutory

    provisions that protect customers and counterparties in other ways, and

    that promote effective market operations and transparency.\440\

    ---------------------------------------------------------------------------

    \439\ See, e.g., letters from CDEU and SIFMA--Regional Dealers.

    \440\ We also disagree with the suggestion that it would be

    inconsistent with the Title VII framework to consider customer

    protection issues in setting the de minimis factors. See letter from

    WGCEF I. While the restrictions on the availability of swaps and

    security-based swaps to non-ECPs help to mitigate certain customer

    protection concerns, Title VII includes specific safeguards designed

    to protect dealers' customers and counterparties regardless of

    whether those are ECPs. It would not be consistent with Title VII to

    ignore those interests.

    ---------------------------------------------------------------------------

    Some commenters also have suggested that the de minimis exception

    should subsume a proportionality

    [[Page 30632]]

    standard, whereby an entity may be excluded from dealer regulation if

    its dealing activity comprises only a relatively small portion of its

    overall activities (or its overall swap or security-based swap

    activities), or if its dealing activity is ``tangential'' to its

    principal business.\441\ We are not incorporating that type of approach

    into the de minimis factors, however, because that approach would not

    appear to provide a logical way to balance the benefits and burdens of

    dealer regulation. A proportionality approach could permit a large

    entity to engage in a significant amount of dealing activity without

    being subject to dealer regulation, thus undermining the benefits of

    dealer regulation. Moreover, a proportionality approach could lead to

    arbitrary results by excusing a large entity from dealer regulation

    while requiring the registration of a smaller entity that engages in

    less total dealing activity (if that smaller amount of dealing activity

    comprises a greater portion of the smaller entity's total

    activity).\442\

    ---------------------------------------------------------------------------

    \441\ See letter from FHLB I.

    \442\ As discussed below, if an entity is a dealer, the

    regulations applicable to dealers in general will govern all of the

    entity's swap or security-based swap activities and positions.

    Depending on the applicable facts and circumstances, however, the

    entity may be able to avail itself of a limited purpose designation

    as a dealer. See part II.E, infra.

    ---------------------------------------------------------------------------

    Some commenters also supported the use of non-quantitative

    standards in connection with the de minimis exception.\443\ Although we

    recognize that such an approach may help us weigh the facts and

    circumstances associated with a particular person's dealing activity,

    we believe that it is more appropriate to base the exception on an

    objective quantitative standard, to allow the exception to be self-

    executing, and to promote predictability among market participants and

    the efficient use of regulatory resources. Unlike the overall

    definitions of ``swap dealer'' and ``security-based swap dealers,''

    which consider the entirety of a person's activities with respect to

    swaps, the de minimis exception is only relevant to persons who have

    determined that they are engaged in swap or security-based swap

    dealing, and are looking to determine whether the quantity of their

    dealing activity is de minimis. For this more particular and focused

    determination, an objective quantitative standard is more appropriate.

    ---------------------------------------------------------------------------

    \443\ See letters from FHLB I, Gavilon II, and MFX II.

    ---------------------------------------------------------------------------

    Commenters also made various suggestions as to the types of factors

    and accompanying thresholds that should be used in connection with the

    de minimis exception. Those suggestions are addressed more specifically

    below in the specific context of the swap dealer and security-based

    swap dealer de minimis exceptions.

    4. Final Rules--De Minimis Exception to Swap Dealer Definition

    a. Overview of the Final Rule

    After considering commenters' views, the final rule implementing

    the de minimis exception caps an entity's dealing activity involving

    swaps at $3 billion over the prior 12 months.\444\ This amount is based

    on input from commenters and is supported by several rationales,

    including the estimated size of the domestic swap market, among others.

    ---------------------------------------------------------------------------

    \444\ CFTC Regulation Sec. 1.3(ggg)(4). As noted above, for the

    first year following the effective date of the rules implementing

    the definition of ``swap'' the analysis would only address activity

    following that effective date. For clarity, the final rule also has

    been revised from the proposal to provide that persons taking

    advantage of the exception ``shall be deemed not to be'' swap

    dealers (the proposed rule used the phrasing ``shall not be deemed

    to be'' swap dealers) The final rule also reflects certain

    structural changes consistent with the substantive changes from the

    proposed rule. In addition, as discussed above, see part II.D.3.d,

    supra, the final rule has been revised to provide that the notional

    thresholds to the de minimis exception encompass swap dealing

    positions entered into by an affiliate controlling, controlled by or

    under common control with the person at issue.

    ---------------------------------------------------------------------------

    As noted above, commenters who suggested a fixed notional standard

    proposed that the standard be set at a level between $200 million and

    $3.5 billion in notional amount of swaps entered into over a period of

    twelve months.\445\ In considering these comments, we are mindful of

    the variety of uses of swaps in various markets and therefore it is

    understandable that various commenters would reach different

    conclusions regarding the appropriate standard. At the same time, we

    see value in setting a single standard for all swaps so that there is a

    ``level playing field'' for all market participants and so that the

    standard can be implemented easily without the need to categorize

    swaps. Considering the written input of the commenters as well as the

    discussions of the de minimis standard at the Commissions' joint

    roundtable and numerous meetings with market participants, and the

    benefits of the regulation of swap dealers (i.e., protection of

    customers and counterparties, and promotion of the effective operation

    and transparency of the swap markets), we believe a notional standard

    at a level of $3 billion appropriately balances the relevant regulatory

    goals.

    ---------------------------------------------------------------------------

    \445\ One commenter suggested a threshold of $3 billion. See

    letter from COPE I (suggesting 0.001% of the total U.S. swap market,

    amounting to approximately $3 billion). Other commenters also

    supported a threshold of 0.001% of the total U.S. swap market. See

    letters cited in note 382, supra.

    ---------------------------------------------------------------------------

    As noted above, several commenters suggested that the standard be

    set at an amount equal to 0.001 percent of the overall domestic market

    for swaps. The Commissions note, however, that comprehensive

    information regarding the total size of the domestic swap market is

    incomplete, with more information available with respect to certain

    asset classes than others. The CFTC evaluated data regarding one

    particular type of swap--credit default swaps (``CDS'') based on

    indices of debt securities known as ``index CDS''--that was provided by

    the SEC.\446\ As noted in the CFTC analysis of this data, however, the

    information is not filtered to reflect activity that would constitute

    swap dealing under the Dodd-Frank Act, so it is not possible to use the

    data to draw conclusions regarding any specific entity's status as a

    swap dealer.\447\ The data reflects only activity relating to index

    CDS, which constitute a very narrow part of the overall swap market,

    and, as noted in the CFTC analysis, similar data regarding other types

    of swaps is not available.\448\ Subject to these limitations, the data

    may help evaluate the impact of alternative approaches to implementing

    the de minimis exception.

    ---------------------------------------------------------------------------

    \446\ The CFTC analysis was made available to the public. See

    memorandum to the public comment file from the CFTC Office of the

    Chief Economist.

    \447\ See id.

    \448\ See id.

    ---------------------------------------------------------------------------

    One often-cited measure of the market, the Quarterly Report on Bank

    Trading and Derivatives Activities issued by the OCC (``OCC Quarterly

    Report'') is both limited, in that it includes only data related to the

    activities of U.S. bank holding companies, commercial banks and trust

    companies, and over-inclusive, in that it includes activities related

    to instruments that are not or may not be included in the final

    definition of ``swap'' (including futures, forwards, certain foreign

    exchange instruments, and certain options) and it includes both swaps

    and security-based swaps. Nonetheless, the Commissions believe that the

    available (imperfect) data suggests that a $3 billion notional standard

    is generally consistent with the commenters' suggestion of basing the

    standard on a percentage of the overall domestic market for swaps.

    The total notional value of $333.1 trillion in ``derivatives''

    stated in the most recent OCC Quarterly Report includes approximately

    $221.1 trillion

    [[Page 30633]]

    in ``swaps'' and ``credit derivatives.'' \449\ Since some instruments

    that are security-based swaps are included in this total,\450\ the

    total notional value of swap positions at U.S. bank holding companies,

    commercial banks and trust companies at the end of the second quarter

    of 2011 of may be estimated to be somewhat less than $221.1 trillion.

    ---------------------------------------------------------------------------

    \449\ See Office of the Comptroller of the Currency, ``Quarterly

    Report on Bank Trading and Derivatives Activities, Second Quarter

    2011'' at tables 1 and 2 (http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq211.pdf). These totals

    reflect the sum of the amounts reported for the top 25 bank holding

    companies reported in table 1 and for all but the top 25 commercial

    banks and trust companies reported in table 2.

    However, this adjustment is only approximate, because the

    definitions of ``swap'' and ``credit derivative'' used in the OCC

    Quarterly Report are likely to be significantly different from the

    final definition of ``swap'' and ``security-based swap'' for

    purposes of the Dodd-Frank Act. For the same reason, it is uncertain

    how many of the notional value of $54.5 trillion in options reported

    in the OCC Quarterly Report are swaps or security-based swaps.

    Also, data from the CDS trade information warehouse maintained

    by the Depository Trust & Clearing Corporation (``DTCC'') indicates

    that total global notional CDS positions on indices amount to

    approximately $10.47 trillion. See http://dtcc.com/products/derivserv/data_table_i.php?tbid=3 (data for the week ending

    October 7, 2011, obtained on October 17, 2011).

    \450\ See part II.D.5, infra, for a discussion of the size of

    the security-based swap market.

    ---------------------------------------------------------------------------

    This total notional value is by nature under-inclusive, because it

    reflects only swap positions at U.S. bank holding companies, commercial

    banks and trust companies and not the swap positions of other market

    participants. However, there are also reasons that the information from

    the OCC Quarterly Report may overstate the notional value of swaps that

    would be relevant to estimating the size of the domestic swap market

    for purposes of the de minimis standard. While we believe the data is

    not sufficiently precise at this time to serve as the sole basis for

    the notional standard, a standard of $3 billion seems that it is likely

    generally consistent with 0.001 percent of the domestic swap market

    that would be relevant to a potential dealer's de minimis swap activity

    figure. First, the large majority of derivatives in the OCC Quarterly

    Report (approximately $229 trillion in notional value for commercial

    banks and trust companies) are derivatives between ``dealers'' (as

    defined for the purposes of the report.) \451\ Thus, it is likely that

    a large part of the derivatives in the OCC Quarterly Report reflect

    transactions between financial institutions that will be swap dealers.

    It is also notable that approximately $204.6 trillion in notional value

    of the derivatives (i.e., not only swaps) reported by U.S. commercial

    banks were interest rate contracts, many of which are swaps entered

    into by IDIs with customers in connection with the origination of loans

    which will be excluded from the determination of whether the IDIs are

    swap dealers.\452\ Finally, the OCC Quarterly Report measures swap

    positions held at a certain point in time, rather than the level of

    swap activity over a certain time period, again indicating that the

    figures are broader than those that would be subject to the de minimis

    figure. Accordingly, it appears that notional amount of the overall

    domestic market for swaps that actually would be relevant to

    determining the notional standard, and thus the appropriate basis for

    the 0.001 percent calculation, may be significantly lower than $331

    trillion.

    ---------------------------------------------------------------------------

    \451\ See OCC Quarterly Report at Graph 1.

    \452\ See OCC Quarterly Report at Graph 3.

    ---------------------------------------------------------------------------

    Because there is merit in the 0.001 percent ratio suggested by

    several commenters, we believe an appropriate balance of the goal of

    promoting the benefits of regulation (while recognizing the

    unquantifiable nature of those benefits) against the competing goal of

    avoiding the imposition of burdens on those entities for which

    regulation as a dealer would not be associated with achieving those

    benefits in a significant way, would be reached by setting the notional

    standard for swaps at a level that is near (taking into account the

    uncertainties noted above) 0.001 percent of a reasonable estimate of

    the overall domestic market for all swaps between all counterparties.

    We believe a $3 billion notional value standard is appropriate taking

    all these considerations into account.

    b. Dealing Activity Involving Special Entities

    For swaps in which the counterparty is a special entity, the final

    rules set a notional standard consistent with the proposal of $25

    million over the prior 12 months.\453\ The Commissions believe that

    this notional standard is appropriate in light of the special

    protections that Title VII affords to special entities. In adopting

    this threshold, we recognize the serious concerns raised by commenters

    stating that the de minimis exception should not permit any dealing

    activities (by persons who are not registered as swap dealers)

    involving special entities, in light of losses that special entities

    have incurred in the financial markets.\454\ However, the final rule

    does not fully exclude such dealing activity from the exception, in

    light of the potential benefits that may arise from a de minimis

    exception. In this way, the threshold would not completely foreclose

    the availability of swaps to special entities from unregistered

    dealers, but the threshold would limit the financial and other risks

    associated with those positions for a special entity, which would in

    turn limit the possibility of inappropriately undermining the special

    protections that Title VII provides to special entities.

    ---------------------------------------------------------------------------

    \453\ CFTC Regulation Sec. 1.3(ggg)(4)(i).

    \454\ See letters from AFR and Better Markets I.

    ---------------------------------------------------------------------------

    c. Phase-in Procedure

    The Commissions believe that a phase-in period for the de minimis

    threshold would facilitate the orderly implementation of Title VII by

    permitting market participants and the Commissions to familiarize

    themselves with the application of the swap dealer definition and swap

    dealer requirements and to consider the information that will be

    available about the swap market, including real-time public reporting

    of swap data and information reported to swap data repositories. In

    addition, a phase-in period would afford the Commissions additional

    time to study the swap markets as they evolve in the new regulatory

    framework and allow potential swap dealers that engage in smaller

    amounts of activity (relative to the current size of the market)

    additional time to adjust their business practices, while at the same

    time preserving a focus on the regulation of the largest and most

    significant swap dealers. The Commissions also recognize that the data

    informing their current view of the de minimis threshold is based on

    the markets as they exist today, and that the markets will evolve over

    the coming years in light of the new regulatory framework and other

    developments.

    We have also considered that there may be some uncertainty

    regarding the exact level of swap dealing activity, measured in terms

    of a gross notional amount of swaps, that should be regarded as de

    minimis. While some quantitative data regarding the usage of swaps is

    available, there are many aspects of the swap markets for which

    definitive data is not available. We have also considered comments

    suggesting that the de minimis thresholds should be set higher

    initially to provide for efficient use of regulatory resources,\455\ or

    that implementation of the dealer requirements should be phased.\456\

    For

    [[Page 30634]]

    all these reasons, the Commissions believe it is appropriate that the

    final rules provide for a phase-in period following the effective date

    during which higher de minimis thresholds would apply.

    ---------------------------------------------------------------------------

    \455\ See letters cited in footnote 402, supra.

    \456\ See, e.g., Roundtable Transcript at 35 (remarks of Ron

    Filler, New York Law School) and letters from FSR dated May 12, 2011

    (``FSR III'') and WGCEF V.

    ---------------------------------------------------------------------------

    In particular, during this phase-in period, a person's swap dealing

    activity over the prior 12 months is capped at a gross notional value

    of $8 billion.\457\ With respect to swaps with special entities, the

    Commissions believe it is appropriate that the $25 million gross

    notional value threshold apply during the phase-in period.\458\ In

    light of the available data--and the limitations of that data in

    predicting how the full implementation of Title VII will affect dealing

    activity in the swap markets--the Commissions believe that the

    appropriate threshold for the phase-in period is an annual gross

    notional level of swap dealing activity of $8 billion or less. In

    particular, the $8 billion level should still lead to the regulation of

    persons responsible for the vast majority of dealing activity within

    the swap markets.

    ---------------------------------------------------------------------------

    \457\ See CFTC Regulation Sec. 1.3(ggg)(4)(i).

    \458\ This limitation regarding swaps with special entities

    during the phase-in period is consistent with the Dodd-Frank Act's

    goal of helping special entities be in a position to benefit from

    the counterparty protections associated with the regulation of

    registered swap dealers under Title VII.

    ---------------------------------------------------------------------------

    Accordingly, the Commissions believe that while a $3 billion

    notional threshold reflects an appropriate long-term standard based on

    the available data,\459\ it also is appropriate to allow a degree of

    latitude in applying the threshold over time in the event that

    subsequent developments in the markets or the evaluation of new data

    from swap data reporting facilities suggest that the thresholds should

    be adjusted. In particular, the implementation of swap data reporting

    under the Dodd-Frank Act may result in new data that would be useful in

    confirming the Commissions' determination to establish the $3 billion

    threshold which applies after the phase-in period.

    ---------------------------------------------------------------------------

    \459\ See, e.g., part II.D.4.a, supra.

    ---------------------------------------------------------------------------

    For these reasons, review of the de minimis exception will comprise

    an important part of the reports that the CFTC is directing its staff

    to conduct with regard to the swap dealer definition during the phase-

    in period. Among other topics, the report should consider market data

    addressing swap dealing activity over a period of approximately two

    years, and any resulting changes in swap dealing activity, by dealers

    above and below the $8 billion phase-in threshold, and above and below

    the $3 billion level applicable after the phase-in period. The report

    is required to be completed by the CFTC staff no later than 30 months

    following the date that a swap data repository first receives swap data

    under the CFTC's regulations, and the report will be published for

    public comment.\460\ The CFTC will take this report, in conjunction

    with any public comment on it, into account in weighing further action

    on the de minimis exception at the end of the phase-in period.

    ---------------------------------------------------------------------------

    \460\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii)(C).

    ---------------------------------------------------------------------------

    The final rules provide that nine months after publication of its

    staff report, the CFTC may, in its discretion, either promulgate an

    order that the phase-in period will end as of the date set forth by the

    CFTC in that order, or issue for public comment a notice of proposed

    rulemaking to modify the de minimis threshold, in which case the CFTC

    would also issue an order establishing the date that the phase-in

    period will end.\461\ The period of nine months provided in the rule is

    intended to provide the CFTC an opportunity to consider its staff

    report, public comments on the staff report and any other relevant

    information.

    ---------------------------------------------------------------------------

    \461\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii)(C).

    ---------------------------------------------------------------------------

    The CFTC recognizes that the determination of the appropriate de

    minimis threshold is a significant issue requiring thorough

    consideration of a variety of regulatory and market factors. At the

    same time, the CFTC recognizes the need for predictability in how the

    de minimis exception will apply. Therefore, the final rules include a

    finality provision, stating that the phase-in period will end no later

    than five years after the date that a swap data repository first

    receives swap data under the CFTC's regulations.\462\

    ---------------------------------------------------------------------------

    \462\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii)(D).

    ---------------------------------------------------------------------------

    Persons who are able to avail themselves of the higher de minimis

    threshold that applies during the phase-in period will not be required

    to do so. In particular, a person that is engaged in dealing activity

    involving swaps in excess of the $3 billion threshold may choose to

    commence the process for registering as a swap dealer during the phase-

    in period.\463\

    ---------------------------------------------------------------------------

    \463\ See CFTC Regulation Sec. 1.3(ggg)(4)(vi).

    ---------------------------------------------------------------------------

    d. CFTC Staff Report

    As noted above, the CFTC is directing its staff to report to the

    CFTC as to whether changes are warranted to the rules implementing the

    swap dealer definition, including the rule implementing the de minimis

    exception. We are mindful that following the full implementation of

    Title VII--which itself is contingent on the implementation of the

    dealer definition--more data will be available to the CFTC via swap

    data repositories. We expect that this additional data will assist the

    CFTC in testing the assumptions and addressing the effects of the final

    rule we are adopting to implement the de minimis exception. For

    example, this data should help the CFTC assess, among other things, the

    nature and amount of unregulated dealing activity that occurs under the

    $3 billion threshold. The CFTC will make this report available for

    public comment so that it may benefit from additional input and

    analysis regarding the swap dealer definition.

    By making use of post-implementation data, the staff report

    (together with public comment on the report) will help the CFTC better

    evaluate the exception in light of potential market changes resulting

    from the full implementation of Title VII--including market changes

    resulting from the de minimis exception itself--as part of determining

    whether revised de minimis thresholds would be appropriate. The report

    and public comment thereon will also be taken into consideration by the

    CFTC in determining what action, if any, to take with respect to the

    phase-in period associated with the de minimis exception.

    The final rules provide, moreover, that the CFTC may change the

    requirements of the de minimis exception by rule or regulation.\464\

    Through this mechanism, the CFTC may revisit the rule implementing the

    exception and potentially change that rule, for example, if data

    regarding the post-implementation swap market suggests that different

    de minimis thresholds would be appropriate.\465\ In determining whether

    to revisit the thresholds, the CFTC intends to pay particular attention

    to whether the de minimis exception results in a swap dealer definition

    that encompasses too many entities whose activities are not

    [[Page 30635]]

    significant enough to warrant full regulation under Title VII, or,

    alternatively, whether the de minimis exception leads an undue amount

    of dealing activity to fall outside of the ambit of the Title VII

    regulatory framework, or leads to inappropriate reductions in

    counterparty protections (including protections for special entities).

    The CFTC also intends to pay particular attention to whether

    alternative approaches would more effectively promote the regulatory

    goals that may be associated with a de minimis exception.

    ---------------------------------------------------------------------------

    \464\ CFTC Regulation Sec. 1.3(ggg)(4)(v). CEA section

    1a(49)(D) (like Exchange Act section 3(a)(71)(D)) particularly

    states that the ``Commission''--meaning the CFTC--may exempt de

    minimis dealers and promulgate related regulations. We do not

    interpret the joint rulemaking provisions of section 712(d) of the

    Dodd-Frank Act to require joint rulemaking here, because such an

    interpretation would read the term ``Commission'' out of CEA section

    1a(49)(D) (and Exchange Act section 3(a)(71)(D)), which themselves

    were added by the Dodd-Frank Act.

    \465\ See letter from Greenberger (stating that the dynamic

    nature of the derivatives sector of the financial markets should

    counsel caution, and that the de minimis threshold should be

    reevaluated on an ongoing basis).

    ---------------------------------------------------------------------------

    5. Final Rules--De Minimis Exception to ``Security-Based Swap Dealer''

    Definition

    a. Overview of the Final Rule

    The final rule implementing the de minimis exception to the

    ``security-based swap dealer'' definition has been revised from the

    proposal in a number of ways. As discussed above, the final rule does

    not incorporate proposed limits on the number of security-based swaps

    that a person may enter into in a dealing capacity, or on the number of

    security-based swap counterparties a person may have when acting in a

    dealing capacity.\466\ Moreover, the provisions of the exception that

    cap an unregistered person's annual notional dealing activity with

    counterparties other than ``special entities'' have been increased from

    the proposed $100 million threshold.\467\ Instead, the final rule caps

    such dealing activity involving security-based swaps that are credit

    default swaps--which largely would consist of single-name credit

    default swaps--at $3 billion in notional amount over the prior 12

    months.\468\ For other types of security-based swaps (e.g., single-name

    or narrow-based equity swaps or total return swaps), the exception caps

    an unregistered person's dealing activity at $150 million in notional

    amount over the prior 12 months.\469\ Also, as addressed below, the

    final rule provides for phase-in levels in excess of those $3 billion

    and $150 million thresholds for a certain period of time.

    ---------------------------------------------------------------------------

    \466\ See part II.D.3.b, supra.

    \467\ For clarity, the final rule also has been revised from the

    proposal to provide that persons taking advantage of the exception

    ``shall be deemed not to be'' dealers (the proposed rule used the

    phrasing ``shall not be deemed to be'' dealers), and to provide that

    such persons ``shall not be subject to Section 15F of the Exchange

    Act and the rules, regulations and interpretations issued

    thereunder.'' See Exchange Act rule 3a71-2(a). The final rule also

    reflects certain structural changes consistent with the substantive

    changes from the proposed rule.

    In addition, as discussed above, see part II.D.3.d, supra, the

    final rule has been revised to provide that the notional thresholds

    to the de minimis exception encompass swap and security-based swap

    dealing positions entered into by an affiliate controlling,

    controlled by or under common control with the person at issue.

    \468\ Exchange Act rule 3a71-2(a)(1)(i). The final rule, like

    the proposal, requires the analysis of de minimis levels to be based

    on effective notional amounts to the extent that the stated notional

    amount is leveraged or enhanced by the structure of the security-

    based swap (such as, for example, if the exchange of payments

    associated with an equity swap was based on a multiple of the return

    associated with the underlying equity). See Exchange Act rule 3a71-

    2(a)(3).

    It is important to recognize that while these types of de

    minimis principles are relevant to the ``security-based swap

    dealer'' definition, they are not applicable to the general

    definitions of ``broker'' and ``dealer'' under the Exchange Act, or

    the broker-dealer registration requirements of Exchange Act section

    15(a). Unlike the ``security-based swap dealer'' definition, those

    other definitions, with the exception of the bank-broker definition

    in section 3(a)(4)(B)(xi) of the Exchange Act, lack de minimis

    exceptions.

    \469\ Exchange Act rule 3a71-2(a)(1)(ii).

    ---------------------------------------------------------------------------

    In addition, consistent with the proposal, the final rule caps an

    unregistered person's security-based swap dealing activity involving

    counterparties that are ``special entities'' at $25 million in notional

    amount over the prior 12 months.\470\ The final rule further provides

    that the SEC may establish alternative methods of determining the scope

    of the de minimis exception by rule or regulation.\471\

    ---------------------------------------------------------------------------

    \470\ Exchange Act rule 3a71-2(a)(1)(iii).

    \471\ Exchange Act rule 3a71-2(d); see part II.D.5.f, infra.

    ---------------------------------------------------------------------------

    b. Interests Associated With a De Minimis Exception

    In developing this final rule, we have sought to balance the

    interests advanced by the de minimis exception against the protections

    that would be weakened were the exception applied in an overbroad

    manner. In making this evaluation, we have taken into account data

    regarding the security-based swap market and especially data regarding

    the activity--including activity that may be suggestive of dealing

    behavior--of participants in the single-name credit default swap

    market.\472\

    ---------------------------------------------------------------------------

    \472\ Certain data has been addressed by an analysis regarding

    the market for single-name credit default swaps performed by the

    SEC's Division of Risk, Strategy, and Financial Innovation. See

    ``Information regarding activities and positions of participants in

    the single-name credit default swap market'' (Mar. 15, 2012)

    (available at http://www.sec.gov/comments/s7-39-10/s73910-154.pdf)

    (``CDS Data Analysis''). We believe that the data underlying this

    analysis provides reasonably comprehensive information regarding the

    credit default swap activities and positions of U.S. market

    participants, but note that the data does not encompass those credit

    default swaps that both: (i) do not involve U.S. counterparties; and

    (ii) are based on non-U.S. reference entities. Our reliance on this

    data, which we believe to be the best available, should not be

    interpreted to indicate our views as to the nature or extent of the

    application of Title VII to non-U.S. persons; instead, the SEC

    anticipates that issues regarding the extraterritorial application

    of Title VII will be addressed in a separate release.

    As discussed below, see notes 476 and 485, infra, we also have

    considered more limited publicly available data regarding equity

    swaps.

    The CDS Data Analysis also included an appendix of data

    regarding index credit default swaps. We do not consider that data

    for purposes of the analysis described in this section because the

    statutory definition of ``security-based swap'' in relevant part

    encompasses swaps based on single securities or on narrow-based

    security indices. See Exchange Act sec. 3(a)(68)(A); see also

    Exchange Act Release No. 64372, 76 FR 29818 (May 23, 2011) (proposed

    rules further defining ``security-based swap'' and certain other

    terms).

    ---------------------------------------------------------------------------

    As discussed above, a de minimis exception eliminates key Title VII

    protections for some market participants by regulating less dealer

    activity. Conversely, an appropriately applied de minimis exception may

    provide an objective test when there is doubt as to whether particular

    activities may cause a person to be deemed to be a dealer; \473\ allow

    non-dealers to accommodate the incidental security-based swap needs of

    existing clients; and help to facilitate competition by allowing the

    entry of new dealers into the market. In addition, as discussed above,

    a de minimis exception may promote regulatory efficiency by providing a

    framework to help focus dealer regulation upon those entities for which

    such regulation is warranted, rather than upon entities that engage in

    relatively limited amounts of dealing activity.\474\

    ---------------------------------------------------------------------------

    \473\ We believe that the application of the dealer-trader

    distinction and the guidance we have provided that distinguishes

    hedging activities from dealing activities in the security-based

    swap market will also help dealers meet their obligations.

    \474\ See part II.D.3.a, supra.

    ---------------------------------------------------------------------------

    i. Providing for Regulatory Coverage of the Vast Majority of Dealing

    Activity

    In seeking to develop a de minimis exception that preserves key

    counterparty and market protections while promoting regulatory

    efficiency, we have considered the comparative amount of security-based

    swap dealing activity that could fall outside the ambit of dealer

    regulation as a result of the exception. In doing so we have considered

    not only the security-based swap market as it currently exists, but

    also how the market reasonably may be expected to change after the full

    implementation of Title VII.

    In performing this comparative exercise we are, in part, drawing

    inferences from the CDS Data Analysis, a dataset released by the SEC

    staff that characterizes nearly all transactions in single-name credit

    default swaps during the 2011 calendar year.\475\ Though the final

    rules apply to all security-based swaps, not just single-name credit

    [[Page 30636]]

    default swaps, the SEC believes that these data are sufficiently

    representative of the market to help inform the analysis because an

    estimated 95 percent of all security-based swap transactions appear

    likely to be single-name credit default swaps.\476\ The SEC also

    recognizes that although the de minimis exception is applicable to

    persons only with respect to their dealing activity, the CDS Data

    Analysis contains transactions reflecting both dealing activity and

    non-dealing activity, including transactions by persons who may engage

    in no dealing activity whatsoever.\477\

    ---------------------------------------------------------------------------

    \475\ See note 472, supra.

    \476\ While recognizing that the Commissions have yet to adopt

    final rules defining a ``security-based swap,'' we believe that

    single-name credit default swaps will constitute roughly 95 percent

    of the market, as measured on a notional basis, for instruments that

    will fall within that definition, with certain equity swaps (in

    other words, total return swaps based on single equities or narrow-

    based indices of equities) constituting the primary example of

    security-based swaps that are not credit default swaps.

    In particular, according to data published by BIS, the global

    notional amount outstanding in equity forwards and swaps as of June

    2011 was $2.03 trillion, and the notional amount outstanding in

    credit default swaps was approximately $32.4 trillion. See

    Statistical Annex, BIS Quarterly Review (December 2011), at A10

    (available at http://www.bis.org/publ/qtrpdf/r_qs1112.pdf).

    Although the BIS data reflects the global OTC derivatives market,

    and not just U.S. market, we have no reason to believe that these

    ratios differ significantly in the U.S. market. In fact, OCC data

    regarding U.S. entities generally confirms these ratios, in that as

    of June 30, 2011, U.S. commercial banks and trust companies held

    $15.23 trillion in notional outstanding credit derivative positions

    and $677 billion in equity derivative positions, meaning that credit

    derivatives accounted for approximately 95 percent of the total

    credit and equity derivative positions held by these entities. See

    OCC Quarterly Report at tables 1 and 10. Cf. letter from Greenberger

    (referencing OCC data as relevant to determining size of swap

    market).

    \477\ A person that is engaged in security-based swap dealing

    activity, for example, may also engage in proprietary trading

    involving security-based swaps that would be reflected in the

    transaction data. Even accounting for such possibilities, however,

    the SEC believes that the data nonetheless support the broad

    conclusion described below that dealing activity within the

    security-based swap market is highly concentrated.

    ---------------------------------------------------------------------------

    As described more fully in the CDS Data Analysis, to ascertain

    which entities might be transacting as dealers, and which may not be,

    various criteria were employed as indicia of possible dealing activity.

    In each case, the results suggest the great extent to which there is

    currently a high degree of concentration of potential dealing activity

    in the single-name credit default swap market. For example, using the

    criterion that dealers are likely to transact with many counterparties

    who themselves are not dealers, analysis of 2011 transaction data show

    that only 28 out of 1,084 market participants have three or more

    counterparties that themselves are not recognized as dealers by

    ISDA.\478\ As the data show, 15 of these 28 potential dealers exceeded

    a threshold of $100 billion notional transacted in single-name credit

    swaps during 2011, which accounts for over 98 percent of the 28

    entities' total activity.\479\ At a lower threshold of $10 billion

    notional, 21 of the 28 potential dealers are included (representing

    99.7 percent of the activity of potential dealers), and at an even

    lower threshold of $3 billion notional, 25 potential dealers are

    included (representing 99.9 percent).\480\

    ---------------------------------------------------------------------------

    \478\ See CDS Data Analysis at table 3c. The SEC recognizes that

    the analysis of this transaction data is imperfect as a tool for

    identifying dealing activity, given that the presence or absence of

    dealing activity ultimately turns upon the relevant facts and

    circumstances of an entity's security-based swap transactions, as

    informed by the dealer-trader distinction. Criteria based on the

    number of an entity's counterparties that are not recognized as

    dealers nonetheless appear to be useful for identifying apparent

    dealing activity in the absence of full analysis of the relevant

    facts and circumstances, given that engaging in security-based swap

    transactions with non-dealers would be consistent with the conduct

    of seeking to profit by providing liquidity to others, as

    anticipated by the dealer-trader distinction. In emphasizing this

    criterion for identifying dealing activity, we are not seeking to

    predict with precision how many entities ultimately may register as

    security-based swap dealers. The ultimate number of dealers that may

    register can also be expected to reflect growth in the market, new

    dealing entrants, and in some cases the registration of multiple

    dealing entities within an affiliated group.

    \479\ See CDS Data Analysis at table 3c. In particular, those 15

    entities engaged in a total of $11.01 trillion in notional single-

    name credit default swap transactions over 2011, which reflects 98.5

    percent of the total $11.18 trillion in notional transactions over

    2011 for the 28 total identified possible dealers.

    \480\ See id. The 21 possible dealers with a 2011 notional in

    excess of $10 billion account for a total of $11.15 trillion in

    notional single-name credit default swap transactions in 2011, or

    over 99.7 percent of the total. The 25 possible dealers in excess of

    $3 billion account for almost $11.18 in notional transactions in

    2011, or over 99.9 percent of the total.

    ---------------------------------------------------------------------------

    Other criteria for identifying possible dealing activity based on

    the number of an entity's non-dealer counterparties similarly suggest a

    high degree of concentration of dealing activity within the current

    security-based swap market.\481\ Criteria that consider the number of

    an entity's total single-name security-based swap counterparties,\482\

    criteria that consider alternative factors for identifying dealing

    activity,\483\ and certain combined criteria \484\ further

    [[Page 30637]]

    suggest a high concentration of dealing activity within the security-

    based swap market.

    ---------------------------------------------------------------------------

    \481\ For example, two other criteria consider the number of an

    entity's non-dealer counterparties (in those cases identifying as

    dealers those persons that have seven or more, or five or more,

    counterparties not recognized as dealers by ISDA) also indicate that

    potential dealers with notional amounts in excess of $100 billion in

    2011 account for over 98 percent of the notional transactions of all

    entities meeting the applicable criteria in 2011. Potential dealers

    with notional transactions above $10 billion in 2011 (let alone

    those with notional transactions above $3 billion) reflect all or

    virtually the entire notional amount of all dealers identified by

    those criteria. See id. at tables 3a and 3b.

    \482\ The CDS Data Analysis also sought to identify dealing

    activity based on the total number of an entity's counterparties.

    See id. at tables 2a through 2c. Those criteria similarly suggest a

    high degree of concentration of dealing activity within the single-

    name credit default swap market:

    i. A criterion that identifies potential dealing activity based

    on an entity having twenty or more counterparties in single-name

    security-based swaps identified 16 possible dealers. Fourteen of

    those entities had notional transactions in excess of $100 billion

    in 2011, reflecting over 99 percent of the total associated with all

    16. The remaining two identified entities had notional transactions

    in excess of $10 billion in 2011. See id. at table 2a.

    ii. A criterion that identifies potential dealing activity based

    on an entity having 15 or more counterparties in single-name

    security-based swaps identified 33 possible dealers. Fifteen of

    those entities had notional transactions in excess of $100 billion

    in 2011, reflecting over 97 percent of the total associated with all

    33. A total of 27 of those entities had notional transactions in

    excess of $10 billion in 2011, and a total of 32 of those entities

    had notional transactions in excess of $3 billion in 2011, both

    reflecting over 99 percent of the total. See id. at table 2b.

    iii. A criterion that identifies potential dealing activity

    based on an entity having 10 or more counterparties in single-name

    security-based swaps identified 154 possible dealers. Fifteen of

    those exceeded $100 billion in notional transactions in 2011,

    reflecting over 90 percent of the total; 49 of those exceeded $10

    billion in notional transactions in 2011, reflecting over 97 percent

    of the total; and 93 exceeded $3 billion in notional transactions in

    2011, reflecting over 99 percent of the total. See id. at table 2c.

    In considering the data we are weighing these criteria less

    heavily than we are weighing the criteria based on the number of

    counterparties who are not identified by ISDA as dealers. This is

    because it is reasonable to foresee a non-dealer making use of

    multiple dealers to get the best possible price or to make use of

    special expertise possessed by certain dealers, meaning that the

    criteria discussed in this footnote are more likely to identify

    entities not engaged in dealing activity.

    \483\ Other criteria in the CDS Data Analysis sought to identify

    dealing activity based on whether an entity maintains a relatively

    flat book. Those criteria also indicated that entities with notional

    transactions in excess of $100 billion in 2011 represented over 97

    percent of the total for all entities identified by those criteria,

    while entities with notional transactions in excess of $10 billion

    in 2011 represented over 99 of the total for all entities identified

    by those criteria. See id. at tables 4 and 5. We are weighing those

    criteria less heavily than we are weighing the counterparty-based

    criteria discussed above because an entity that engages in

    directional trades could also appear to have a flat book if its

    portfolio contained transactions representing various directional

    bets, but of similar aggregate notional sizes on both sides of the

    market. See id. at 3.

    The analysis also included one criterion that considers

    potential dealing activity based on a low propensity to post margin.

    See id. at table 6. While we do not believe that this analysis

    deserves the same degree of weight as the others, given concerns

    about the completeness of the data (see id. at 4), we note that this

    criterion nonetheless also indicates a high concentration of dealing

    activity in the market. See id. at table 6 (indicating that of the

    473 entities identified by this criterion, the 14 entities with

    notional transactions in excess of $100 billion in 2011 account for

    roughly 94 percent of the total notional transaction activity

    associated with all 473 entities over 2011).

    \484\ Finally, the CDS Data Analysis also included criteria that

    identified potential dealing activity based on an entity meeting two

    or three of the other criteria considered. See id. at tables 7 and

    8. These criteria again indicate a high degree of concentration of

    dealing activity in the market. The analysis that addressed whether

    an entity met two of the other criteria identified 92 possible

    dealers, with the 15 entities having notional transactions in excess

    of $100 billion in 2011 representing over 96 percent of the total

    activity of those 92 entities in 2011. See id. at table 7. The

    analysis that addressed whether an entity met three of the other

    criteria identified 41 possible dealers, with the 15 entities having

    notional transactions in excess of $100 billion in 2011,

    representing over 98 percent of the total activity of those 41

    entities in 2011. See id. at table 8.

    ---------------------------------------------------------------------------

    While less data are available in connection with other types of

    instruments constituting security-based swaps, such as equity swaps,

    the available data similarly suggest a high concentration of positions

    in those instruments among potential dealers.\485\

    ---------------------------------------------------------------------------

    \485\ For example, OCC data shows that, of the five largest bank

    or trust companies, four have notional equity derivative positions

    of above $1 billion, and that those four entities account for $630

    billion in notional positions out of $677 billion for all U.S.

    commercial banks or trust companies, which constitutes approximately

    93 percent of the total. See OCC Quarterly Report at table 10.

    Similarly, a review of the equity swaps positions of the 50 largest

    U.S. bank holding companies shows that nine bank holding companies

    have notional equity swap positions exceeding $1 billion, and

    account for 99.5 percent of the total positions held by such

    companies, and 29 have no positions in equity swaps. (Data was

    compiled from each bank holding company's FR 9-YC, available at

    http://www.ffiec.gov/nicpubweb/nicweb/Top50Form.aspx). Cf. letter

    from WGCEF V (referencing swap position data from bank holding

    companies' Forms FR Y-9C as relevant to determining size of the swap

    market).

    ---------------------------------------------------------------------------

    Though inspection of the data does not seem to suggest a single

    precise de minimis threshold, the above analysis of potential dealing

    activity is useful in that it reveals a range of possible thresholds

    from $100 billion to $3 billion that would cover anywhere from 98

    percent through 99.9 percent of the total activity of all potential

    dealers in 2011. However, these thresholds--and their implied market

    coverage ratios--only reflect levels of activity that exist in today's

    highly concentrated market. In order to further narrow the range of

    possible thresholds, and to select an appropriate level for the de

    minimis exception, the analysis must consider the potential state of

    the market as it might reasonably exist after the implementation of

    Title VII.

    ii. Avoiding Gaps Resulting From the Regulatory Changes in Conjunction

    With the Exception

    Although the overall portion of security-based swap activity that

    would appear to be subject to dealer regulation based on current

    measures of dealing concentration in the market constitutes an

    important factor to consider in balancing the regulatory burdens and

    benefits associated with a de minimis exception, analysis of the

    current market should not serve as the sole mechanism for setting the

    exception.

    In particular, sole reliance on an approach that focuses on current

    measures of market concentration would not adequately account for

    likely changes to the market associated with the implementation of

    regulation. In part, these changes may be a direct result of the full

    implementation of Title VII--including enhancements to transparency and

    increases in central clearing--as those changes reasonably may be

    expected to reduce the concentration of dealing activity within the

    market over time.\486\ Also, to the extent implementation of Title VII

    permits new dealers to enter the market, the availability of a de

    minimis exception would mean those new dealing entrants would fall

    outside the ambit of dealer regulation, either for the long term or

    until their dealing activity surpasses the applicable notional

    threshold.\487\ Accordingly, de minimis thresholds that are based

    solely on the current state of the market, including the current

    concentration of dealing activity within the market, may reasonably be

    expected to fail to account for the amount of dealing activity that in

    the future could fall outside of the ambit of dealer regulation due to

    the exception.\488\

    ---------------------------------------------------------------------------

    \486\ Cf. Bessembinder and Maxwell, ``Transparency and the

    Corporate Bond Market,'' Journal of Economic Perspectives, Spring

    2008, at 217, 226 (noting that after reporting of U.S. OTC bond

    transactions through the Trade Reporting and Compliance Engine

    (``TRACE'') became mandatory, the portion of trades completed by the

    12 largest dealers fell from 56 percent to 44 percent).

    \487\ We understand that large dealers have competitive

    advantages under the current market, in light of the desire of

    counterparties to engage in security-based swap transactions with

    large, well capitalized and highly rated dealers. See, e.g., Craig

    Pirrong, Rocket Science, Default Risk and The Organization of

    Derivatives Markets, Working Paper, University of Houston (2006)

    (available at http://www.cba.uh.edu/spirrong/Derivorg1.pdf). The

    lower business costs associated with being unregulated may prove to

    partially offset that advantage. At the same time, we reasonably may

    expect that informed counterparties will take into account the lower

    protections--and higher risks--associated with transactions with

    unregulated dealers in determining whether to use regulated or

    unregulated dealers as counterparties.

    \488\ We note that there also are benefits to increased

    competition and a decrease in concentration of dealer activity, as

    contemplated by Title VII, including potentially lower costs for

    market participants and a decrease in systemic risk.

    ---------------------------------------------------------------------------

    For example, as discussed above, when possible dealers in single-

    name credit default swaps are identified by an entity having three or

    more counterparties that are not recognized by ISDA as being dealers,

    entities with notional transactions in excess of $100 billion over a 12

    month period represent over 98 percent of the total activity of all

    such possible dealers over that period, leaving two percent of possible

    dealing activity below that level.\489\ However, a de minimis threshold

    of $100 billion would allow new entrants to commence engaging in

    unregulated dealing in competition with persons who are regulated as

    dealers pursuant to Title VII, which, depending on the number and size

    of such entrants, could significantly decrease the portion of dealing

    activity in the market done by registered dealers (at least until the

    point that new entrants cross the de minimis threshold, if they do at

    all). For example, if 15 new entrants \490\ were to engage in security-

    based swap dealing activity up to a $100 billion threshold, the result

    could be that nearly 15 percent of dealing activity within the single-

    name credit default swap market would be left outside of the ambit of

    dealer regulation.\491\

    ---------------------------------------------------------------------------

    \489\ See CDS Data Analysis at table 3c; see also note 479,

    supra. As noted above, these amounts may not only reflect dealing

    activity by an entity. Thus, even putting aside the possibility of

    new unregulated entrants into the market, the portion of dealing

    activity in the market that is represented by entities whose

    trailing notional dealing activity exceeds $100 billion may in fact

    be less than 98 percent.

    \490\ The illustrative use of new entrants for purposes of this

    discussion is intended to reflect the potential that new entrants to

    the market could take advantage of a de minimis threshold in a way

    that leads to a higher level of unregulated dealing activity within

    the market. In using this illustration we are not seeking to

    explicitly predict how many new entrants may come into the market in

    response to any particular de minimis threshold, nor are we seeking

    to predict how many new entrants may seek to stay under the de

    minimis thresholds and how many instead would seek to use the

    exception as a step on the way to eventually registering as a

    security-based swap dealer. Rather, we simply are illustrating why

    it is important to account for market changes in connection with

    setting the de minimis threshold.

    The OTC Derivatives Supervisors Group--a group chaired by the

    Federal Reserve Bank of New York and consisting of the CFTC and SEC

    as well as other international supervisors and major over-the-

    counter derivatives market participants--currently recognizes 15

    major OTC derivatives dealers. Accordingly, as an illustrative

    example, we have assumed that this number of significant security-

    based swap dealers would approximately double--i.e., include 15 new

    dealers--in the wake of the various regulatory changes contemplated

    by the Dodd-Frank Act, many of which may result in increased access

    and competition in the security-based swap market (e.g., enhanced

    priced transparency and increased access to central clearing).

    However, we emphasize that this number has been selected as an

    illustrative example, and have accordingly provided similar examples

    assuming ten and five new entrants.

    \491\ Fifteen new entities that each engage in $100 billion in

    dealing activity would reflect $1.5 trillion in additional dealing

    activity outside the ambit of dealer regulation, which could lead to

    roughly 14.9 percent of total dealing activity being outside the

    ambit of dealing regulation (with that $1.5 trillion being added to

    the existing $168 billion reflected by entities that fall below the

    $100 billion threshold, and that sum divided by $11.18 trillion,

    under the assumption that the new entrants displace business from

    the fifteen entities above the de minimis threshold). To further

    illustrate, under the same assumptions and analysis, the implied

    unregulated market share would be roughly 10.4 percent for ten new

    entities and 6.0 percent for five new entities.

    In certain regards these illustrations, on the one hand, may

    overestimate the effect of new entrants because of the assumption

    that such entrants engage in dealing activities up to, but not

    surpassing, the de minimis threshold. While it is not impossible

    that some entities may seek to use the de minimis exception to

    conduct business as an unregulated niche dealer, it also is

    plausible that entities generally may seek to use the exception to

    commence engaging in dealing activity, with the goal of ultimately

    becoming registered dealers that are not constrained by the de

    minimis threshold.

    On the other hand, these illustrations in certain respects may

    underestimate the amount of dealing activity that can fall outside

    of the regulatory ambit. For example, the amounts of security-based

    swap activity of persons identified in the analysis as dealers may

    not exclusively constitute dealing activity, meaning that persons

    whose notional transactions over a 12-month period exceed a

    particular threshold in fact may not be engaged in that amount of

    dealing activity, and hence may still be able to take advantage of

    the de minimis exception. Also, these illustrations do not seek to

    reflect increased activity by existing dealers that already fall

    below the assumed threshold.

    ---------------------------------------------------------------------------

    [[Page 30638]]

    Similarly, a de minimis threshold of $25 billion may also lead to a

    material reduction in the portion of the market covered by registered

    dealers. For example, using the same assumptions as above, 15 new

    entrants up to a $25 billion threshold could leave over four percent of

    dealing activity in the market outside of the ambit of dealing

    regulation.\492\ When other metrics are used to identify possible

    dealing activity, the possibility of a significant regulatory gap

    remains.\493\

    ---------------------------------------------------------------------------

    \492\ Fifteen new entities each engaged in $25 billion in

    dealing activity would reflect $375 billion in additional dealing

    activity outside the ambit of dealer regulation, which could lead to

    4.1 percent of total dealing activity being outside the ambit of

    dealing regulation (with that $375 billion being added to the

    existing $80.2 billion reflected by entities that fall below the $25

    billion threshold, and that sum divided by $11.18 trillion, under

    the assumption that the new entrants displace business from the

    seventeen entities above the de minimis threshold). To further

    illustrate, under the same assumptions and analysis, the implied

    unregulated market share would be 3.0 percent for 10 new entities

    and 1.8 percent for 5 new entities. Obviously, these illustrations

    are subject to the same limitations as are discussed above in the

    context of the $100 million threshold illustration.

    \493\ For example, similar results are obtained when possible

    dealing activity is identified based on whether an entity passes at

    least three of the other metrics discussed above. See CDS Data

    Analysis at table 8. Using the same types of assumptions as are

    discussed above, with fifteen new entities, a de minimis threshold

    of $100 billion could lead to 15.0 percent of dealing activity

    falling outside the ambit of dealer regulation, while a de minimis

    threshold of $25 billion could lead to 4.2 percent of dealing

    activity falling outside of regulation.

    ---------------------------------------------------------------------------

    Overall, it is reasonable to conclude that the higher the de

    minimis threshold, the greater the likelihood that the exception,

    combined with other changes resulting from the implementation of Title

    VII that may encourage new entrants, will lead to a proportionately

    larger amount of unregulated (except with respect to antifraud and

    anti-manipulation prohibitions) dealing activity.\494\ We believe that

    it is reasonable to interpret the statutory language of the de minimis

    exception in a way that prevents a proportionately large amount of

    dealing activity within the security-based swap market from falling

    outside the ambit of dealer regulation. Accordingly, choosing to set a

    lower de minimis threshold from among the range of potential thresholds

    would limit the amount of potential future dealing activity that could

    be transacted without being subject to dealer rules and

    regulations.\495\

    ---------------------------------------------------------------------------

    \494\ As noted above, encouraging new entrants also has benefits

    flowing from increased competition and a decrease in concentration

    of dealer activity. See note 488, supra.

    \495\ For example, 15 new dealer entrants engaged in up to $3

    billion in dealing activity would account for up to $45 billion in

    dealing activity. This result would mean approximately 0.4 percent

    of total potential future dealing activity could be transacted by

    unregistered dealers, as opposed to the potential for approximately

    15 percent of potential future dealing activity to be transacted by

    unregistered dealers if the de minimis were set to $100 billion. See

    CDS Data Analysis at table 3c. As with the illustrative examples

    above, these calculations assume that the new entrants displace

    business from the entities above the de minimis threshold.

    ---------------------------------------------------------------------------

    iii. Promoting Statutory Counterparty Protections

    Sole reliance on an approach based on overall market coverage in

    balancing regulatory burdens and benefits would also threaten to unduly

    discount important counterparty protection interests, as discussed

    above and highlighted in the proposal.\496\ For example, in light of

    data indicating that $5 million constitutes a common notional size for

    a single-name credit default swap position,\497\ a de minimis notional

    threshold of $25 billion annually would permit an unregistered dealer

    to engage in as many as 5000 trades of that size. The counterparties to

    these unregistered dealers would not receive the benefit of the

    protections that Title VII affords to the counterparties of registered

    dealers. These include, among others, the segregation protections

    afforded to persons who post margin to dealers in connection with over-

    the-counter security-based swap transactions.\498\ Accordingly, this

    consideration also suggests that choosing a de minimis threshold closer

    to the lower end of the range of potential thresholds would better

    preserve the counterparty protections contemplated by Title VII.

    ---------------------------------------------------------------------------

    \496\ See part II.D.3.a, supra; see also Proposing Release at

    80180 (highlighting ``customer protection issues raised by swaps and

    security-based swaps--including risks that counterparties may not

    fully appreciate when entering into swaps and security-based

    swaps'').

    \497\ See Federal Reserve Bank of New York staff report, ``An

    Analysis of CDS Transactions: Implications for Public Reporting''

    (2011) at 8 (stating that for dollar-denominated single name CDS on

    corporate or sovereign reference entities, $5 million represented

    the most common notional size) (available at http://www.newyorkfed.org/research/staff_reports/sr517.pdf); see also

    Proposing Release at 80180 (noting ``that in general the notional

    seize of a small swap or security-based swap is $5 million or

    less'').

    We note, by comparison, that Congress has determined that a de

    minimis amount of securities broker activity by banks entails 500

    trades annually. See Exchange Act section 3(a)(4)(B)(xi) (excluding

    from the ``broker'' definition a bank that annually effects no more

    than 500 securities transactions, other than transactions subject to

    certain other exceptions, so long as the transaction is not effected

    by a bank employee that also is a broker-dealer employee).

    We further note that, while the number of counterparties or

    transactions potentially implicated by unregistered dealing activity

    is an important consideration in establishing an initial de minimis

    level, it does not alter our view, described above, that a single de

    minimis standard based on notional value--rather than the proposal's

    framework of three distinct standards based on notional value,

    number of counterparties, and number of transactions--is an

    appropriate choice in light of concerns expressed by commenters that

    a standard based on the number of transactions or counterparties can

    produce arbitrary results. See part II.D.3.b.ii, supra.

    \498\ Exchange Act section 3E, which was added by section 763(d)

    of the Dodd-Frank Act, provides a series of requirements in

    connection with the segregation of assets held as collateral in

    security-based swap transactions. These include requirements that

    security-based swap dealers and major security-based swap

    participants provide their counterparties with notice that they have

    the right to require segregation, and that such segregation must be

    at an independent third-party custodian.

    ---------------------------------------------------------------------------

    c. Balancing Reflected in the Final Rules--Credit Default Swaps That

    Constitute Security-Based Swaps

    The final thresholds that implement the de minimis exception (and

    corresponding phase-in levels) address security-based swaps that are

    credit default swaps separately from other types of security-based

    swaps, in light of differences in the respective markets.

    i. General Threshold for Credit Default Swaps That Constitute Security-

    Based Swaps

    We conclude that $3 billion over the prior 12 months constitutes an

    appropriate notional threshold for applying the de minimis exception in

    connection with dealing activity involving credit default swaps that

    constitute security-based swaps.

    [[Page 30639]]

    In reaching this conclusion, we recognize the significance of

    comments that supported the proposed $100 million threshold,\499\ and

    that urged caution in raising that proposed threshold,\500\ as well as

    commenters who supported increases to the threshold.\501\ We further

    recognize the importance of applying the de minimis exception in a way

    that promotes regulatory efficiency. We also recognize the range of

    potential thresholds suggested by the data currently available. Based

    on the competing factors described above, we believe that $3 billion

    reflects a reasonable notional threshold--though not necessarily the

    only such threshold.

    ---------------------------------------------------------------------------

    \499\ See letters from Better Markets I and AFR.

    \500\ See letter from Greenberger.

    \501\ See, e.g., letter from COPE I.

    ---------------------------------------------------------------------------

    In our view, the currently available data regarding the single-name

    credit default swap market indicates that a notional threshold of $3

    billion would be expected to result in the regulation, as dealers, of

    persons responsible for the vast majority of dealing activity within

    that market, both as of today and, as described above, in the future as

    the benefits of the other Title VII rules are implemented and new

    dealer entrants come to market.\502\

    ---------------------------------------------------------------------------

    \502\ Of the 28 market participants that have three or more

    security-based swap counterparties that themselves are not

    recognized by dealers by ISDA, 25 had notional single-name credit

    default swap positions in excess of $3 billion in 2011. The

    remaining three entities in total accounted for only $3.59 billion

    in notional transactions in 2011, reflecting less than 0.1 percent

    of the $11.18 trillion total for those 28 market participants. See

    CDS Data Analysis at table 3c.

    The other criteria set forth in the analysis for identifying

    possible dealing activity in general similarly indicate that

    entities with notional transactions in excess of $3 billion in 2011

    account for more than 99 percent of the total notional transactions

    of all identified entities in 2011. See id. at tables 2a-c, 3a-b, 4,

    5, 7 and 8. While the criterion based on the posting of initial

    margin only indicates 98 percent coverage for all of the 473

    identified entities, see id. at table 6, as discussed above we

    believe it is appropriate to provide less weight to that criterion,

    which is based on voluntary reporting.

    As noted above, see note 478, supra, we recognize that the

    underlying market data encompasses all of the security-based swap

    activity of persons identified as dealers, not only their dealing

    activity. Because the thresholds that implement the de minimis

    exception address only a person's dealing activity, this raises the

    possibility that the analysis overstates the extent to which a $3

    billion threshold would encompass persons responsible for dealing

    activity within the single-name security-based swap market. Even

    with that possibility, however, we believe that the data indicates

    such a high concentration of dealing activity within the market that

    it is reasonable to conclude that a $3 billion threshold likely

    would encompass persons responsible for the vast majority of dealing

    activity within the market.

    ---------------------------------------------------------------------------

    In providing for a $3 billion notional threshold, we also recognize

    the threshold would permit an unregistered dealer annually to engage in

    up to 600 security-based swaps (as opposed to 20 transactions under the

    proposed threshold, assuming a $5 million average notional size). In

    this regard, we note that Congress, in another statutory de minimis

    exception within the Exchange Act, determined that 500 securities

    transactions annually constituted a de minimis amount of transactions

    for banks under the ``broker'' definition.\503\ We further believe that

    a $3 billion threshold appropriately addresses commenter concerns

    regarding the de minimis exception being unduly narrow.\504\

    ---------------------------------------------------------------------------

    \503\ See Exchange Act section 3(a)(4)(B)(xi); see also letter

    from SIFMA--Regional Dealers (supporting a threshold of 500 trades

    consistent with the statutory de minimis exception in connection

    with bank brokerage activity).

    \504\ For example, $3 billion is equal to the threshold

    suggested by many commenters in the context of the swap market,

    which is much larger than the security-based swap market. See letter

    from COPE (supporting a 0.001 percent notional threshold based on

    the overall swaps market, which would amount to $3 billion). Indeed,

    this $3 billion threshold appears to reflect roughly 0.024 percent

    of the overall market for single-name credit default swaps, a

    percentage that is much greater than the 0.001 percent multiplier

    that a number of commenters (see, e.g., letters cited in note 382,

    supra) suggested in the swap market context. See CDS Data Analysis

    at table 1 (indicating that participants in the single-name credit

    default swap market engage in a total of $12.6 trillion in single-

    name credit default swap transactions in 2011).

    ---------------------------------------------------------------------------

    In adopting this $3 billion threshold, we have carefully considered

    one commenter's view that the CDS Data Analysis suggests that the

    proposed $100 million threshold in fact is too high, and that any

    increase in that proposed $100 million threshold would be arbitrary and

    capricious.\505\ In reaching these conclusions, the commenter focused

    on the number of entities that potentially are engaged in dealing

    activity but that could be excluded based on particular de minimis

    thresholds. For example, the commenter indicated that pursuant to one

    of the CDS Data Analysis's combined metrics for identifying dealing

    activity, a de minimis threshold of $3 billion could lead to the

    exclusion of up to 58 percent of all persons engaged in possible

    dealing activity. The commenter further suggested that some entities

    engaged in dealing activity may reduce their activities to take

    advantage of the de minimis exception and hence reduce liquidity, and

    argued that there would be no basis for the exception to be based on a

    market participant's percentage of total security-based swap

    activity.\506\

    ---------------------------------------------------------------------------

    \505\ See letter from Better Markets III.

    \506\ The letter also raised issues regarding the ``customer''

    language of the exception and argued that the de minimis exception

    should not represent a risk-based test. We address those issues

    elsewhere. See parts II.D.3.c (regarding ``customer'' language) and

    II.D.3.e (regarding rejection of risk-based and proportionality

    tests), infra.

    In addition, the letter expressed the view that a percentage-

    based formula would be difficult to implement, by requiring market

    participants to repeatedly calculate the ratio of their activity to

    total market activity. We concur. The $3 billion threshold we are

    adopting reflects a fixed dollar amount, and does not share the

    complications that would arise from an approach based on a

    particular percentage of the market.

    ---------------------------------------------------------------------------

    It is important to recognize that while the commenter focused on

    the number of entities that might be excluded pursuant to the

    exception, and suggested that higher notional dollar amount thresholds

    could lead to the exclusion of a larger number of entities, the

    statutory provision for the de minimis exception does not require the

    exemption of a ``de minimis number'' of dealers. The statute instead

    requires the exemption of persons engaged in a ``de minimis quantity''

    of dealing activity.\507\ The statutory language therefore indicates

    that the focus of the rule implementing the exception should be the

    amount of an entity's dealing activity, not how many entities

    ultimately may be able to take advantage of the exception.

    ---------------------------------------------------------------------------

    \507\ See Exchange Act section 3(a)(71)(D).

    ---------------------------------------------------------------------------

    Also, although the commenter implied that there would be no basis

    for the rule implementing the exception to take into account a market

    participant's security-based swap dealing activity compared to total

    dealing activity in the market, for the reasons discussed in this

    section we believe that such an approach can appropriately provide for

    the regulatory coverage of the vast majority of dealing activity in a

    way that promotes regulatory efficiency, without leading to unwarranted

    regulatory gaps. In contrast, in our view the commenter did not

    persuasively articulate a strong rationale for adopting the alternative

    approach proposed in the letter, which would appear to lead to the

    registration of a number of dealers that proportionately engage in a

    very small amount of dealing activity.\508\

    ---------------------------------------------------------------------------

    \508\ The commenter correctly pointed out that the regulatory

    requirements applicable to registered dealers encompass counterparty

    protection requirements, and that the de minimis exception should

    not defeat those requirements. We recognize that the implementation

    of the exception should take those counterparty protections into

    account, and we have sought to do so. We do not believe, however,

    that those important counterparty protection goals require a de

    minimis approach that focuses on the number of entities that would

    be excluded, in lieu of the statutory focus on whether a particular

    entity engages in a de minimis quantity of dealing activity.

    ---------------------------------------------------------------------------

    In support of its approach, the commenter emphasized data regarding

    persons who meet certain combined criteria outlined in the CDS Data

    [[Page 30640]]

    Analysis. As discussed above, we believe that criteria based on the

    number of an entity's counterparties that are not recognized as dealers

    deserve special weight due to the potential consistency of those

    criteria with the dealer-trader distinction.\509\ Identifying dealer

    activity using those criteria does not support the view that a $3

    billion threshold would lead to the exclusion of a large number of

    entities engaged in dealing activity.\510\

    ---------------------------------------------------------------------------

    \509\ See notes 478, 482, and 483, supra.

    \510\ For example, the CDS Data Analysis identifies:

    Three possible dealers with notional transactions below

    $3 billion in 2011--out of a total of 28 possible dealers--when

    possible dealing activity is based on having three or more

    counterparties that themselves are not identified as dealers;

    One possible dealer with notional transactions below $3

    billion in 2011- out of a total of 20 possible dealers--when

    possible dealing activity is based on having five or more

    counterparties that themselves are not identified as dealers; and

    Zero possible dealers with notional transactions below

    $3 billion in 2011--out of a total of 16 possible dealers--when

    possible dealing activity is based on having seven or more

    counterparties that themselves are not identified as dealers.

    See CDS Data analysis at tables 3c, 3b and 3a.

    In addition, as described above, an approach focused on the

    quantity of activity is supported by relatively consistent results

    depending on which criterion from the CDS Data Analysis is applied--

    i.e., each criterion shows a high amount of concentration and a

    commensurately low quantity of activity below the $3 billion

    threshold. By contrast, applying different criteria results in very

    different numbers of entities excluded under any specified

    threshold, suggesting that an approach focused on the number of

    entities may be highly dependent on how the possible dealing

    activity of those entities is defined.

    ---------------------------------------------------------------------------

    Finally, we also are not persuaded by the commenter's suggestion

    that a number of entities engaged in dealing activity would reduce

    those activities to take advantage of a $3 billion de minimis

    threshold, and hence reduce liquidity in the market by five percent. To

    reach that figure, the commenter needed to exclude the vast majority of

    dealing activity in the market.\511\ While we recognize that it is

    possible that current market participants may adjust their dealing

    activity in light of the de minimis threshold, and that this

    potentially could reduce the liquidity provided by certain entities, we

    also recognize that the de minimis exception has the potential to

    promote liquidity by facilitating new entrants into the market.

    ---------------------------------------------------------------------------

    \511\ In particular, in arguing that this incentive would reduce

    liquidity by five percent, the commenter excluded all business done

    by entities within the top two brackets (i.e., above $100 billion

    notional), on the grounds that those entities ``are assumed to

    transact mostly with larger entities.'' Based on the criteria on

    which the commenter relied, those 15 entities are responsible for

    over 96 percent of the activity of all possible dealers. See CDS

    Data Analysis at tables 7 and 8. Absent that exclusion, the

    estimated reduction of liquidity would amount to a small fraction of

    a percent.

    ---------------------------------------------------------------------------

    ii. Phase-in Period in Connection With Dealing Activity Involving

    Credit Default Swaps That Constitute Security-Based Swaps

    The final rules further provide that persons with notional dealing

    activity of $8 billion or less over the prior 12 months involving

    credit default swaps that constitute security-based swaps would be able

    to avail themselves of a phase-in period.\512\ Those persons would not

    be subject to the generally applicable compliance date that occurs no

    later than 60 days following publication of these final rules in the

    Federal Register.\513\

    ---------------------------------------------------------------------------

    \512\ Exchange Act rule 3a71-2(a)(2).

    \513\ Even with the general 60 day compliance period, however,

    market participants will not necessarily be security-based swap

    dealers at the end of 60 days. In particular, for the first year

    following the effective date of the final rules implementing the

    definition of ``security-based swap'' pursuant to the Exchange Act

    section 3(a)(68), the de minimis analysis would only address

    security-based swap dealing activity following that effective date.

    See Exchange Act rule 3a71-2(a)(1). Among other things, this means

    that until the rules defining ``security-based swap'' are effective,

    no market participants would be deemed to be security-based swap

    dealers.

    ---------------------------------------------------------------------------

    The use of a phase-in period--in connection with a person's status

    as a security-based swap dealer and in connection with the other

    regulatory requirements that are appurtenant to dealer status--is

    intended to facilitate the orderly implementation of Title VII. In

    addition, the phase-in period will afford the SEC additional time to

    study the security-based swap market as it evolves in the new

    regulatory framework and will allow potential dealers that engage in

    smaller amounts of activity (relative to the current size of the

    market) additional time to adjust their business practices, while at

    the same time preserving the focus of the regulation on the largest and

    most significant dealers. The SEC also recognizes that the data

    informing its current view of the de minimis threshold is based on the

    market as it exists today, and that the market will evolve over the

    coming years in light of the new regulatory framework and other

    developments.

    Accordingly, while the SEC believes that a $3 billion notional

    threshold reflects an appropriate long-term standard based on the

    currently available data,\514\ it also is appropriate to provide for a

    phase-in period for those entities with $8 billion or less in dealing

    activity, because subsequent developments in the market or the

    evaluation of new data from the security-based swap reporting

    facilities contemplated by the Dodd-Frank Act may suggest that the

    threshold should be increased or decreased. In particular, the

    implementation of security-based swap data reporting under the Dodd-

    Frank Act will result in significant new data and afford an opportunity

    to review the Commission's determination to establish a $3 billion

    threshold.

    ---------------------------------------------------------------------------

    \514\ See note 502, supra.

    ---------------------------------------------------------------------------

    For these reasons, an important part of the report that the SEC is

    directing its staff conduct with regard to the definitions of

    ``security-based swap dealer'' and ``major security-based swap

    participant'' (described in detail below) will be a consideration of

    the operation of the de minimis exception following the full

    implementation of Section 15F under Title VII.\515\ The SEC will take

    into account this report, along with public comment on the report, in

    determining whether to propose any changes to the rule implementing the

    de minimis exception, including any increases or decreases to the $3

    billion threshold. The report will be linked to the availability of

    data regarding the activity of regulated security-based swap market

    participants in that it must be completed no later than three years

    \516\ following a ``data collection initiation date'' that is the later

    of: the last compliance date for the registration and regulatory

    requirements for security-based swap dealers and major security-based

    swap participants under Section 15F of the Exchange Act; or the first

    date on which compliance with the trade-by-trade reporting rules for

    credit-related and equity-related security-based swaps to a registered

    security-based swap data repository is required.\517\

    ---------------------------------------------------------------------------

    \515\ See Exchange Act rule 3a71-2A(a)(1); see also part V,

    infra.

    \516\ See Exchange Act rule 3a71-2A(b).

    \517\ The SEC will announce the data collection initiation date

    on its Web site and publish it in the Federal Register. See Exchange

    Act rule 3a71-1(a)(2)(iii).

    ---------------------------------------------------------------------------

    In light of the available data--and the limitations of that data in

    predicting how the full implementation of Title VII will affect dealing

    activity in the security-based swap market--the SEC believes that $8

    billion constitutes an appropriate level for the availability of the

    phase-in period. The available data indicate that such a level

    generally comports with the balance of interests that informed the

    determination of the appropriate long-term threshold of $3 billion

    described above. In particular, the $8 billion level should still lead

    to the regulation of persons responsible for the vast majority of

    dealing activity

    [[Page 30641]]

    within the market.\518\ In addition, we do not believe that providing a

    phase-in period for persons with notional dealing activity over the

    prior 12 months of less than $8 billion would lead to a risk of an

    undue portion of the market falling outside of the ambit of dealer

    regulation, even after considering the potential entry of unregulated

    new dealers into the market.\519\

    ---------------------------------------------------------------------------

    \518\ Of the 28 market participants that have three or more

    security-based swap counterparties that themselves are not

    recognized by dealers by ISDA, 23 had notional single-name credit

    default swap transactions in excess of $8 billion in 2011. The

    remaining five entities in total accounted for only $12.3 billion in

    notional transactions in 2011, reflecting roughly 0.1 percent of the

    $11.18 total for the 28 market participants. See CDS Data Analysis

    at table 3c. Only two of the 28 entities identified as possible

    dealers by that criterion had annual notional transactions between

    $3 billion and $8 billion in 2011.

    Most of the other criteria set forth in the analysis for

    identifying possible dealing activity in general similarly indicate

    that entities with notional transactions in excess of $8 billion in

    2011 account for more than 99 percent of the total notional

    transactions of all identified entities that year. See id. at tables

    2a-b, 3a-b, 4 and 5. While the criterion based on an entity having

    10 or more counterparties only indicates 98 percent coverage for all

    of the 154 identified entities at an $8 billion transaction level,

    see id. at table 2c, as noted above this criterion may identify

    persons who in reality are not engaged in dealing activity. See note

    482, supra. Also, while the criterion based on the posting of

    initial margin only indicates 97 percent coverage for all of the 473

    identified entities at an $8 billion transaction level, see id. at

    table 6, as discussed above that criterion is based on voluntary

    reporting.

    \519\ For example, 15 new dealer entrants up to $8 billion in

    annual notional dealing activity would account for $120 billion in

    dealing activity. This would amount to roughly 1.2 percent of the

    total notional single-name security-based swap activity over 12

    months of entities identified as possible dealers by virtue of

    having three or more counterparties that are not recognized by

    dealers by ISDA. See CDS Data Analysis at table 2c.

    ---------------------------------------------------------------------------

    The final rule provides that the phase-in period will continue

    until the ``phase-in termination date'' that the SEC will publish on

    its Web site and in the Federal Register.\520\ In particular, the rule

    provides that nine months following publication of that report, and

    after giving due consideration of the report and associated public

    comment, the SEC may either: (1) Terminate the phase-in period and by

    order establish and publish the phase-in termination date; or (2)

    determine that it is necessary or appropriate in the public interest to

    propose an alternative de minimis threshold, in which case the SEC, by

    order published in the Federal Register, will provide notice of that

    determination and establish the phase-in termination date.\521\ If the

    SEC does not establish the phase-in termination date in either of those

    ways, the phase-in termination date shall automatically occur in any

    event on what would be a date certain, which will be five years

    following the data collection initiation date.\522\

    ---------------------------------------------------------------------------

    \520\ Exchange Act rule 3a71-2(a)(2)(i).

    \521\ Exchange Act rule 3a71-2(a)(2)(iii)(A).

    \522\ Exchange Act rule 3a71-2(a)(2)(iii)(B).

    ---------------------------------------------------------------------------

    These provisions should allow sufficient time for the staff to

    complete its report, for the SEC to receive and review public comment

    on the report, and for the SEC to draw conclusions regarding

    establishing the phase-in termination date or proposing potential

    changes to the rule implementing the de minimis exception, in a way

    that also promotes the orderly and predictable termination of the

    phase-in period.\523\

    ---------------------------------------------------------------------------

    \523\ This approach balances the fact that the SEC believes that

    its $3 billion and $150 million de minimis thresholds are

    appropriate in light of the currently available data and the

    market's need for a degree of certainty as to the length of this

    phase-in period, on the one hand, against the possibility that the

    staff report and the accompanying public comment may demonstrate

    that revision to these thresholds is necessary, on the other hand.

    ---------------------------------------------------------------------------

    This phase-in period will not be available in connection with the

    $25 million threshold for dealing activity involving special entities,

    discussed below. In addition, the final rule provides that this phase-

    in period will not be available in connection with security-based swap

    dealing activities involving natural persons, other than natural

    persons who qualify as ECPs by virtue of CEA section 1a(18)(A)(xi)(II),

    which addresses natural persons who have $5 million or more invested on

    a discretionary basis and who enter into a security-based swap to

    manage the risk associated with their assets and liabilities.\524\

    These limitations to the availability of the phase-in period are

    consistent with the Dodd-Frank Act's goal of helping special entities

    be in a position to benefit from the counterparty protections

    associated with the regulation of registered security-based swap

    dealers under Title VII, as well as the SEC's mandate to protect

    participants in the securities markets.

    ---------------------------------------------------------------------------

    \524\ See Exchange Act rule 3a71-2(a)(2)(i). In other words, the

    phase-in period will still be available in connection with dealing

    activities with natural persons who are ECPs because they have

    entered into a security-based swap for hedging purposes. While we

    recognize the importance of Title VII protections to natural persons

    who engage in security-based swap activity, we also recognize the

    benefit of facilitating such persons' use of security-based swaps as

    hedges. Accordingly, persons who engage in dealing activity with

    natural persons who are ECPs under other provisions of the ECP

    definition will be subject to the applicable de minimis threshold

    for all of their dealing activity, without the availability of the

    phase-in period.

    Persons who engage in dealing activity with natural persons who

    are not ECPs will fall within the Exchange Act definition of

    ``dealer,'' which has no de minimis exception. See Exchange Act

    section 3(a)(5)(A) (generally excluding dealers in security-based

    swaps from the Exchange Act definition of ``dealer,'' unless the

    counterparty is not an ECP).

    ---------------------------------------------------------------------------

    Persons who are able to avail themselves of the phase-in period, of

    course, will not be required to do so. Any person that chooses to

    register with the SEC as a security-based swap dealer shall be deemed

    to be a security-based swap dealer subject to all applicable regulatory

    requirements for such registrants, regardless of whether the person

    engages in security-based swap dealing activity in an amount that is

    below the applicable de minimis threshold or phase-in level.\525\

    ---------------------------------------------------------------------------

    \525\ See Exchange Act rule 3a71-2(e).

    ---------------------------------------------------------------------------

    d. Balancing Reflected in the Final Rules--Other Types of Security-

    Based Swaps

    The final rule provides that the de minimis exception for dealing

    activity involving security-based swaps other than credit default swaps

    will be based on a threshold of $150 million notional over the prior 12

    months.\526\ In addition, a phase-in period will be available in

    connection with persons whose dealing activity involving those

    instruments is $400 million or less in notional amount over the prior

    12 months.

    ---------------------------------------------------------------------------

    \526\ Exchange Act rule 3a71-2(a)(1)(ii). The proposal requested

    comment on whether different segments of the security-based swap

    market should be treated differently. See Proposing Release at 80101

    (``Commenters further are requested to address * * * whether the [de

    minimis] exemption's factors should vary depending on the type of

    swap or security-based swap at issue.'').

    ---------------------------------------------------------------------------

    These amounts reflect roughly one-twentieth of the corresponding

    amounts associated with the exception for credit default swaps that

    constitute security-based swaps. As discussed above, while less data is

    available regarding other types of security-based swaps than is

    available regarding single-name credit default swaps, the available

    data is consistent in indicating that those other types of security-

    based swaps on a notional basis currently comprise roughly one-

    twentieth of the total amount of instruments that will be expected to

    constitute security-based swaps.\527\ In light of this significantly

    smaller market, we believe that a $3 billion notional threshold would

    threaten to cause an overly large portion of dealing activity within

    the market to fall outside the ambit of dealer regulation.

    ---------------------------------------------------------------------------

    \527\ See note 476, supra.

    ---------------------------------------------------------------------------

    In this regard, we note that it is likely that there are fewer

    barriers to entry in connection with acting as a dealer in security-

    based swaps such as equity swaps and total return swaps on debt than

    there are in connection with acting as a dealer in single-name credit

    default

    [[Page 30642]]

    swaps.\528\ We also note that because equity swaps and total return

    swaps on debt can serve as close economic proxies for equity and debt

    securities, an overly broad de minimis threshold in connection with

    such instruments could threaten to undermine the Exchange Act framework

    for regulating persons who act as dealers in equity and debt.

    ---------------------------------------------------------------------------

    \528\ For example, persons registered with the SEC as broker-

    dealers in connection with other types of securities would appear to

    be well positioned to act as dealers in connection with equity

    swaps, as such broker-dealers already would be expected to have

    systems in place to enter into equity positions to hedge their

    equity swap dealing positions.

    ---------------------------------------------------------------------------

    At the same time--notwithstanding the smaller scope of this market

    and the lesser availability of data regarding dealing activity within

    the market--we do not believe that it is necessary to make the de

    minimis exception unavailable in connection with dealing activity

    involving security-based swaps that are not credit default swaps. In

    this regard we particularly note that the limited available data

    regarding equity swaps suggests a high degree of concentration in

    dealing activity involving those instruments,\529\ which indicates that

    an appropriately sized de minimis threshold can be expected to promote

    regulatory efficiency.

    ---------------------------------------------------------------------------

    \529\ As noted above, four commercial banks and trust companies

    accounted for 93 percent of all equity positions held by such

    companies as of June 30, 2011, and nine bank holding companies

    accounted for over 99 percent of all equity positions held by the

    fifty largest such companies as of December 2011. See note 485,

    supra.

    ---------------------------------------------------------------------------

    Balancing those factors, we conclude that a $150 million annual

    notional threshold is appropriate to implement the de minimis exception

    in connection with security-based swaps that are not credit default

    swaps, consistent with our understanding of the comparative size of

    that market as applied to the threshold applicable to credit default

    swap dealing activity. For reasons similar to those described above, we

    conclude that there should be a phase-in period available to persons

    whose annual notional dealing activity in connection with security-

    based swaps that are not credit default swaps is no more than $400

    million in annual 12-month notional amount. This phase-in period is

    subject to the same limitations regarding transactions involving

    special entities and natural persons as apply to the phase-in period

    for credit default swaps. It also will be subject to the same

    provisions regarding the termination of the phase-in period as apply in

    connection with credit default swaps.\530\ The comparative lack of data

    involving these markets--in contrast to the market for single-name

    credit default swaps--particularly highlights how the use of a phase-in

    period that is linked to the availability of post-implementation data

    is appropriate.\531\

    ---------------------------------------------------------------------------

    \530\ See Exchange Act rule 3a71-2(a)(2); see also notes 520

    through 522, supra, and accompanying text.

    \531\ The SEC expects that the staff report should be especially

    helpful for providing data regarding dealing activity in connection

    with those other types of security-based swaps to consider the

    impact of the termination of the phase-in period, as well as

    potential changes to the de minimis exception in connection with

    these instruments.

    ---------------------------------------------------------------------------

    As above, a person who is eligible to take advantage of the phase-

    in period in connection with these types of security-based swaps may

    nonetheless register as a security-based swap dealer.

    e. Dealing Activity Involving Special Entities

    Consistent with the proposal, the final rules in general will cap

    an entity's dealing activity involving security-based swaps at no more

    than $25 million notional amount over the prior 12 months when the

    counterparty to the security-based swap is a special entity.\532\ There

    will be no phase-in period in connection with transactions involving

    special entities. In adopting this threshold, we recognize the serious

    concerns raised by commenters that stated that the de minimis exception

    should not permit any dealing activities involving special entities in

    light of losses that special entities have incurred in the financial

    markets,\533\ as well as the special protection that Title VII affords

    special entities.\534\

    ---------------------------------------------------------------------------

    \532\ Exchange Act rule 3a71-2(a)(1)(iii).

    \533\ See letters from AFR and Better Markets I.

    \534\ In this regard we note that Title VII authorizes the SEC

    to impose special business conduct requirements when a security-

    based swap dealer is counterparty to a special entity. See Exchange

    Act section 15F(h)(5). In proposing rules to implement these

    requirements, the SEC requested comment regarding the scope of the

    ``special entity'' definition, including, for example, regarding

    whether the SEC should interpret ``special entity'' to exclude a

    collective investment vehicle in which one or more special entities

    have invested. See Exchange Act Release No. 64766 (June 29, 2011),

    76 FR 42396, 42422 (July 18, 2011). For purposes of interpreting

    this special entity threshold to the de minimis exception--

    particularly with regard to when a special entity would be a

    counterparty to a person that is engaged in dealing activity--the

    SEC believes that it will be appropriate to be guided by final

    interpretations regarding when a dealer will be a counterparty to a

    special entity for purposes of those business conduct requirements.

    ---------------------------------------------------------------------------

    At this time, the final rule does not fully exclude such dealing

    activity from the exception, in light of the potential benefits that

    may arise from a de minimis exception. In this way, the threshold would

    not completely foreclose the availability of security-based swaps to

    special entities from unregistered dealers--as $25 million would

    annually accommodate up to five single-name credit default swaps of a

    $5 million notional size--but the threshold would limit the financial

    and other risks associated with those positions for a special entity,

    which would in turn limit the possibility of inappropriately

    undermining the special protections that Title VII provides to special

    entities.

    In reaching this conclusion we recognize that special entities do

    participate in the single-name credit default swap market, given that

    an analysis of market data indicates that in 2011 special entities were

    parties to over $40 billion in single-name credit default swap

    transactions.\535\ At the same time, the impact of this $25 million

    threshold--particularly concerns that the threshold may foreclose the

    ability of special entities to access dealers in the market--appears to

    be mitigated by the fact that the counterparties to those special

    entities tend to engage in notional transactions in single-name credit

    default swap well in excess of the general de minimis standards.\536\

    In light of the underlying counterparty protection issues, we see no

    basis to distinguish between types of security-based swaps in setting

    this special entity threshold.

    ---------------------------------------------------------------------------

    \535\ See CDS Data Analysis at table 9.

    \536\ See id. at n.8 (noting that the average notional activity

    of those 16 counterparties was $680 billion, with the lowest being

    approximately $9 billion).

    ---------------------------------------------------------------------------

    For similar reasons, in the future as we consider whether to amend

    the de minimis exception we expect to pay particular attention to

    whether the threshold for transactions involving special entities

    should further be lowered.

    f. Future Revisions to the Rule

    As noted above and described in detail below in part V, the SEC is

    directing its staff to report on whether changes are warranted to the

    rules and interpretations implementing the security-based swap dealer

    definition, including the rule implementing the de minimis

    exception.\537\ The SEC will take the report and associated public

    comment into account in determining whether to propose any changes to

    the rule implementing the exception.\538\ Consistent with that

    possibility, the final rule provides that the SEC may change the

    requirements of the de minimis exception by rule or regulation.\539\

    Through this mechanism,

    [[Page 30643]]

    the SEC may revisit the rule implementing the exception and potentially

    change that rule, for example, if data regarding the security-based

    swap market following the implementation of Section 15F under Title VII

    suggests that different de minimis thresholds would be

    appropriate.\540\ In determining whether to revisit the thresholds, the

    SEC intends to pay particular attention to whether the de minimis

    exception results in a dealer definition that encompasses too many

    entities whose activities are not significant enough to warrant full

    regulation under Title VII, or, alternatively, whether the de minimis

    exception leads an undue amount of dealing activity to fall outside of

    the ambit of the Title VII regulatory framework, or leads to

    inappropriate reductions in counterparty protections (including

    protections for special entities). The SEC also intends to pay

    particular attention to whether alternative approaches would more

    effectively promote the regulatory goals that may be associated with a

    de minimis exception.

    ---------------------------------------------------------------------------

    \537\ See Exchange Act rule 3a71-2A(a)(1).

    \538\ See notes 520 through 522, supra, and accompanying text.

    \539\ Exchange Act rule 3a71-2(d). Exchange Act section

    3(a)(71)(D) particularly states that the ``Commission''--meaning the

    SEC--may exempt de minimis dealers and promulgate related

    regulations. We do not interpret the joint rulemaking provisions of

    section 712(d) of the Dodd-Frank Act to require joint rulemaking

    here, because such an interpretation would read the term

    ``Commission'' out of Exchange Act section 3(a)(71)(D), which itself

    was added by the Dodd-Frank Act.

    \540\ See letter from Greenberger (stating that the dynamic

    nature of the derivatives sector of the financial markets should

    counsel caution, and that the de minimis threshold should be

    reevaluated on an ongoing basis).

    ---------------------------------------------------------------------------

    6. Registration Period for Entities That Exceed the De Minimis Factors

    The de minimis exception raises implementation issues akin to those

    associated with the major participant definition, in that both

    provisions use tests that have retrospective elements to determine

    whether an entity must register and be subject to future regulation. As

    a result, some commenters have suggested that entities that surpass the

    de minimis thresholds should be able to take advantage of a grace

    period to undertake the process of registering as swap dealers or

    security-based swap dealers.\541\ Otherwise, absent such a ``roll-in''

    period, entities whose dealing activities surpass the relevant de

    minimis factors would immediately be in violation of dealer

    registration requirements. In light of these concerns, and the interest

    of avoiding undue market disruptions, the Commissions believe that it

    is appropriate to provide entities that exceed applicable the de

    minimis factors a period of time to register as dealers.

    ---------------------------------------------------------------------------

    \541\ See letters from Northland Energy and WGCEF I.

    ---------------------------------------------------------------------------

    Accordingly, the final rules have been revised from the proposal to

    provide for a timing standard that is similar to what we are using in

    connection with the major participant definition.\542\ That is, if an

    entity that has relied on the de minimis exception no longer is able to

    rely on the exception because its dealing activity exceeds a relevant

    threshold, the entity would have two months, following the end of the

    month in which it no longer is able to take advantage of the exception,

    to submit a completed application to register as a swap dealer or

    security-based swap dealer.\543\

    ---------------------------------------------------------------------------

    \542\ Compare CFTC Regulation Sec. 1.3(hhh)(3); Exchange Act

    rule 3a67-8(a) (providing that persons who meet the criteria to be

    major participants will have two months to submit a completed

    registration application).

    \543\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii); Exchange Act

    rule 3a71-2(b). As discussed below with regard to the implementation

    period for the major participant definitions, persons will have

    additional time to comply with the applicable requirements following

    the submission of a completed application. See part IV.L.3, infra.

    ---------------------------------------------------------------------------

    Also, akin to the major participant definitions,\544\ a person

    registered as a swap dealer or security-based swap dealer may apply to

    withdraw that registration, while continuing to engage in a limited

    amount of dealing activity in reliance on the de minimis exception, if

    that person has been registered as a dealer for at least 12

    months.\545\ This should help ensure that persons do not rapidly move

    in and out of dealer status based on short-term fluctuations in their

    swap or security-based swap activities.

    ---------------------------------------------------------------------------

    \544\ Compare CFTC Regulation Sec. 1.3(hhh)(5); Exchange Act

    rule 3a67-8(c) (providing that a major participant may be deemed to

    no longer be a major participant if its swap or security-based swap

    positions are below the relevant thresholds for four quarters).

    \545\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii); Exchange Act

    rule 3a71-2(c). Consistent with this approach, moreover, the final

    rule has been revised from the proposal to clarify that the de

    minimis exception in general is not available to a registered swap

    dealer or security-based swap dealer. See CFTC Regulation Sec.

    1.3(hhh)(1)(i); Exchange Act rule 3a71-2(a)(1) (revised language

    clarifying availability of exception to a person that is not a swap

    dealer or security-based swap dealer).

    ---------------------------------------------------------------------------

    The final rules implementing the de minimis exception do not

    provide any reevaluation period for entities that engage in a level of

    dealing activity above the de minimis thresholds, in contrast to the

    major participant definitions.\546\ We do not believe that there is an

    appropriate basis for such a provision, particularly given that dealer

    regulation addresses customer protection and market operation and

    transparency concerns apart from risk concerns.

    ---------------------------------------------------------------------------

    \546\ Compare CFTC Regulation Sec. 1.3(hhh)(4); Exchange Act

    rule 3a67-8(b) (providing for a reevaluation period in connection

    with the major participant definitions when a person does not exceed

    any applicable threshold by more than 20 percent in a calendar

    quarter).

    ---------------------------------------------------------------------------

    E. Limited Purpose Designation as a Dealer

    1. Proposed Approach

    The definitions of the terms ``swap dealer'' and ``security-based

    swap dealer'' provide that the Commissions may designate a person as a

    dealer for one type, class or category of swap or security-based swap,

    or specified swap or security-based swap activities, without the person

    being considered a dealer for other types, classes, categories or

    activities.\547\

    ---------------------------------------------------------------------------

    \547\ CEA section 1a(49)(B); Exchange Act section 3(a)(71)(B).

    ---------------------------------------------------------------------------

    In the Proposing Release, we noted that these provisions represent

    permissive grants of authority that do not require the Commissions to

    provide limited designations.\548\ We further stated that a person that

    is covered by the definitions of the terms ``swap dealer'' or

    ``security-based swap dealer'' would be considered a dealer for all

    types, classes or categories of the person's swaps or security-based

    swaps, or activities involving swaps or security-based swaps, in light

    of the difficulty of seeking to separate a person's dealing activities

    from their non-dealing activities involving swaps or security-based

    swaps, unless such person sought and received designation as a dealer

    for only specified categories of swaps or security-based swaps, or

    specified activities.\549\ We explained that this would provide persons

    the opportunity to seek a limited designation based on applicable facts

    and circumstances, and that we anticipated that a dealer could seek a

    limited designation at the time of its initial registration or

    later.\550\

    ---------------------------------------------------------------------------

    \548\ See Proposing Release, 75 FR at 80182.

    \549\ See id.; see also proposed CFTC Regulation Sec.

    1.3(ggg)(3); proposed Exchange Act rule 3a71-1(c).

    \550\ See Proposing Release, 75 FR at 80182.

    ---------------------------------------------------------------------------

    In the Proposing Release, the CFTC further noted that non-financial

    entities such as physical commodity firms potentially may conduct

    dealing activity through a division rather than through a separately

    incorporated subsidiary, and that such an entity's swap dealing

    activity would not be a core component of its overall business. The

    CFTC added that if this type of entity registered as a dealer, certain

    swap dealer requirements would apply to the dealing activities of the

    division, but not necessarily to the swap activities of other parts of

    the entity.\551\

    ---------------------------------------------------------------------------

    \551\ See id.

    ---------------------------------------------------------------------------

    [[Page 30644]]

    2. Commenters' Views

    A number of commenters addressed the limited designation of dealers

    in conjunction with the limited designation of major participants. Many

    of the issues those commenters raised thus are relevant to both sets of

    definitions.

    a. Presumption of Full Designation

    A number of commenters objected to the proposed presumption that an

    entity would be designated as a dealer (or major participant) for all

    categories of swaps or security-based swaps and all of the person's

    activities connected to swaps or security-based swaps. Several

    commenters argued that this approach would be contrary to Congressional

    intent,\552\ conflict with the statutory language,\553\ or conflict

    with underlying policy concerns.\554\ One commenter suggested that the

    Commissions lack the statutory authority to apply swap dealer

    requirements to an entity's non-swap dealing activities.\555\

    ---------------------------------------------------------------------------

    \552\ See letters from Cargill Incorporated (``Cargill''), CDEU

    and Investment Company Institute (``ICI'') dated February 22, 2011

    (``ICI I'').

    \553\ See letters from MetLife and WGCEF I.

    \554\ See letter from Cargill (stating that limited designation

    promotes the policy of encouraging non-financial firms that

    primarily are engaged in non-dealing businesses to continue to

    conduct limited dealing activities, adding that such firms ``do not

    present the potential systemic risks of financial firms,'' and that

    their full designation as dealers would discourage them from

    providing risk management products).

    \555\ See letter from EDF Trading.

    ---------------------------------------------------------------------------

    b. Potential Types of Limited Designations

    A number of commenters addressed potential types of limited

    designations. One expressed support for limited swap dealer

    designations for particularized business units and for particular swap

    categories,\556\ while another requested that limited swap dealer

    designations be available based on any reasonable commercial

    groupings.\557\ Some commenters urged that limited dealer designations

    should be available for the branches or business units of foreign swap

    dealers and security-based swap dealers with U.S.-based customers or

    U.S. business lines.\558\

    ---------------------------------------------------------------------------

    \556\ See letter from Capital One.

    \557\ See letters from NCGA/NGSA II (particularly referring to

    groupings based on individual physical commodities) and WGCEF dated

    June 9, 2011 (``WGCEF VII'') (limited designation should permit

    firms to structure organization of limited purpose registrans as

    appropriate in particular circumstances).

    \558\ See letters cited in note 148, supra.

    ---------------------------------------------------------------------------

    c. Applications for Limited Designations

    A number of commenters addressed issues relating to the application

    process for limited designations. Some commenters supported the ability

    of a person to apply for limited designations at the time of initial

    registration,\559\ while one commenter sought clarification on how and

    when a person could apply for limited swap dealer status.\560\ Some

    commenters suggested that entities should be considered to have a

    provisional limited designation upon the filing of a completed

    application for limited dealer designation.\561\

    ---------------------------------------------------------------------------

    \559\ See letters from MFA I (specifically requesting that the

    rules provide that an entity can receive a limited purpose

    designation at the time of their initial registration) and FSR I.

    \560\ See letter from National Futures Association (``NFA'').

    \561\ See letters from Capital One, Farm Credit Council I and

    FHLB I.

    ---------------------------------------------------------------------------

    Some commenters requested further clarification as to what factors

    or criteria would be considered relevant to limited designation

    determinations.\562\ One commenter stated that non-financial companies

    should have a presumption of limited swap dealer designation under

    certain circumstances.\563\ Another commenter took the view that

    commercial firms should be able to determine whether to register a

    legal entity or a division as a dealer.\564\ One commenter suggested

    the analysis consider the complexity of an entity's dealing and non-

    dealing activities, and further suggested that limited designations

    should automatically be available if an entity's dealing activities do

    not exceed 50 percent of its total swap activities.\565\ Commenters

    also raised issues related to how a person's status as a financial or a

    non-financial entity affects a person's eligibility for limited

    designations.\566\

    ---------------------------------------------------------------------------

    \562\ See letters from BG LNG I and ISDA I.

    \563\ See letter from Cargill (arguing that a firm should be

    presumptively entitled to limited swap dealer status if: it is a

    non-financial company; its non-dealing activities include (but need

    not be limited to) production, merchandising or processing of

    physical commodities; the firm's dealing activities take place in a

    separately identifiable division or business unit with separate

    management; and dealing revenues are less than 30 percent of the

    firm's total revenues in the firm's most recent fiscal year).

    \564\ See letter from WGCEF VII (stating that so long as a

    registered swap dealer bears the onus of demonstrating compliance

    with regulatory requirements, regulators ``should not dictate''

    whether the firm registers a legal entity or a division as a dealer;

    also requesting guidance as to how applicable regulatory

    requirements may apply to a subdivision of a legal entity that

    registers as a dealer, and requesting a safe harbor from enforcement

    action when a decision to register only a particular desk or

    division as a dealer is made in good faith).

    \565\ See letter from Capital One.

    \566\ Compare letter from Capital One (stating that all market

    participants, including financial institutions, should be allowed to

    apply for limited swap dealer designations) with letter from Cargill

    (suggesting that an entity's status as a financial company should be

    relevant to limited dealer determinations).

    ---------------------------------------------------------------------------

    d. Application of Regulatory Requirements to Limited Dealers

    Commenters also addressed issues related to the application of

    regulatory requirements to limited dealers. One commenter recommended

    that dealer regulatory requirements generally should apply only to a

    division undertaking limited dealing activities; that commenter further

    stated that capital requirements should be calculated based only on the

    activities of that division, while recognizing that capital must be

    held by the entity as a whole.\567\ Other commenters argued that

    capital and margin requirements should only be applied to an entity on

    a limited basis.\568\

    ---------------------------------------------------------------------------

    \567\ See letter from Cargill.

    \568\ See letter from FSR I (recommending that to the extent

    that capital requirements are tied to swap activity or exposures,

    that only activities or exposures in the designated category be

    reflected in the calculation).

    ---------------------------------------------------------------------------

    e. Miscellaneous Issues

    One commenter recommended that non-financial entities that are

    deemed to be limited dealers (or major participants) be permitted to be

    treated as end-users for the aspects of their businesses that are not

    subject to the limited designation.\569\ The commenter further

    suggested that the swaps ``push-out'' rule requirements of section 716

    of the Dodd-Frank Act be interpreted so that an insured depository

    institution that is a limited purpose dealer would only have to push

    out the dealing portion of its swap business, and be allowed to retain

    the other aspects of its swaps business.\570\ One commenter requested

    clarification as to whether a person that is a limited purpose dealer

    in connection with one category of swap could be a major participant in

    connection with another category (in light of the statutory language

    excluding dealers from the major participant definitions).\571\

    ---------------------------------------------------------------------------

    \569\ See id. (recommending that the corporate treasurer of an

    entity with a limited designation as a swap dealer for ``other

    commodity swaps'' as a result of its energy derivatives activity be

    able to hedge the entity's interest rate and currency risk without

    being subject to the business conduct, reporting, recordkeeping or

    other rules applicable to dealers and major participants).

    \570\ See id.

    \571\ See letter from NFA. As discussed below, see 752, infra, a

    person who is designated as a dealer in connection with particular

    types of swaps or security-based swaps may be major participants

    with regard to other types.

    ---------------------------------------------------------------------------

    3. Final Rules and General Principles

    Consistent with the proposal, the final rules retain the

    presumption that a

    [[Page 30645]]

    person who meets one of the dealer definitions will be deemed to be a

    dealer with regard to all of its swaps or security-based swaps

    activities, unless the CFTC or SEC exercises its authority to limit the

    person's designation as a dealer to specified categories of swaps or

    security-based swaps, or specified activities.\572\ As discussed in the

    Proposing Release, moreover, a person may apply for a limited

    designation when it submits a registration application, or at a later

    time.\573\ The final rules also contain a technical change from the

    proposed rules to clarify that limited designations may be based on a

    particular type, class or category of swap or security-based-swap.\574\

    ---------------------------------------------------------------------------

    \572\ CFTC RegulationSec. 1.3(ggg)(3); Exchange Act rule 3a71-

    1(c).

    \573\ The SEC expects to address the process for submitting an

    application for limited designation as a security-based swap dealer,

    along with principles to be used by the SEC in analyzing such

    applications, as part of separate rulemakings.

    \574\ The rules particularly have been revised from the proposal

    to add ``type'' and ``class'' language to supplement the use of the

    term ``category.'' This change is consistent with the statutory

    language. In addition, the final rules related to limited

    designations for ``security-based swap dealers'' corrects an

    erroneous reference to major participant designation.

    ---------------------------------------------------------------------------

    a. Default Presumption of Full Designation

    Consistent with the proposal, the final rules retain the standard

    that a person that satisfies the ``swap dealer'' or ``security-based

    swap dealer'' definition in general would be considered a dealer for

    all types, classes or categories of the person's swaps or security-

    based swaps, or all activities involving swaps or security-based swaps.

    The Commissions are not persuaded by the suggestion that this

    presumption is inconsistent with the statute, legislative intent or

    underlying policy. Not only is the relevant statutory language written

    as a grant of authority rather than a specific mandate to designate

    certain entities as limited purpose dealers, but the presumption also

    reasonably reflects the difficulty of separating a dealer's dealing

    activities from its non-dealing activities, and the challenges of

    applying dealer regulatory requirements to only a portion of a dealer's

    swap or security-based swap activities.\575\

    ---------------------------------------------------------------------------

    \575\ This approach also is consistent with the treatment of

    dealers of other types of securities under the Exchange Act. When a

    person's securities activities cause them to be a ``dealer'' for

    purposes of the Exchange Act, the statutory requirements and

    regulations applicable to dealers will apply to all of that person's

    securities activities, regardless of whether particular activities

    would not have caused the entity to fall within the ``dealer''

    definition. For example, Exchange Act section 15(c)(3)(A) prohibits

    brokers and dealers from engaging in certain securities-related

    activity in contravention of SEC-prescribed rules with respect to

    financial responsibility or related practices. This provision does

    not distinguish between those activities that cause a person to fall

    within the ``broker'' or ``dealer'' definitions, and other

    activities that themselves do not cause that person to be a broker

    or dealer. The SEC's authority extends to all securities activities

    by those brokers or dealers.

    ---------------------------------------------------------------------------

    We similarly are not persuaded by the view that the Commissions

    lack the authority to apply dealer regulation to non-dealing activities

    of a registered swap dealer or security-based swap dealer.\576\ Certain

    of the statutory requirements applicable to swap dealers and security-

    based swap dealers--such as capital requirements--simply do not

    distinguish between a person's dealing activities and their non-dealing

    activities.\577\ In other words, absent a limited designation, the

    statutory requirements applicable to dealers address the regulation of

    all of a dealer's swap or security-based swap activities.\578\

    ---------------------------------------------------------------------------

    \576\ See letter from EDF Trading.

    \577\ See, e.g., CEA section 4s(e); Exchange Act section 15F(e).

    \578\ The substantive regulations applicable to dealers, of

    course, can account for the nature of a dealer's particular swap or

    security-based swap activities.

    The SEC also intends to address limited designation issues in

    the context of a separate release addressing the application of

    Title VII to non-U.S. entities.

    ---------------------------------------------------------------------------

    b. Demonstration of Compliance With Dealer Requirements

    The Commissions will consider limited purpose applications on an

    individual basis through analysis of the unique circumstances of each

    applicant, given that the types of entities that engage in swap or

    security-based swap dealing are diverse and their organization and

    activities are varied.\579\

    ---------------------------------------------------------------------------

    \579\ Consistent with this approach, applications to limit a

    person's dealer designation to ``specified categories'' of swaps or

    security-based swaps (see CFTC Regulation Sec. 1.3(ggg)(3);

    Exchange Act rule 3a71-1(c)), would not be required to interpret the

    term ``category'' consistently with the use of that term in

    connection with the major participant definitions. CFTC Regulation

    Sec. 1.3(iii) and Exchange Act rule 3a67-2, defining the terms

    ``major swap category'' and ``major security-based swap category,''

    respectively, do not apply for this purpose.

    ---------------------------------------------------------------------------

    Regardless of the type of limited designation being requested, the

    Commissions will not designate a person as a limited purpose dealer

    unless it can demonstrate that it can fully comply with the

    requirements applicable to dealers.

    Certain of the statutory requirements applicable to dealers

    particularly focus on the entity's swap or security-based swap

    activities and positions. These include, among other aspects,

    requirements related to trading records, documentation and

    confirmations.\580\ An applicant for a limited purpose designation

    would have to demonstrate how it would satisfy those transaction-

    specific requirements in the context of a limited designation.

    ---------------------------------------------------------------------------

    \580\ See, e.g., CEA section 4s(h)(3), Exchange Act section

    15F(h)(3) (business conduct standards, including disclosure

    requirements, for dealers); CEA section 4s(g), Exchange Act section

    15F(g) (daily trading record requirements for dealers); CEA section

    4s(i); Exchange Act section 15F(i) (documentation requirements for

    dealers).

    ---------------------------------------------------------------------------

    Other statutory requirements applicable to dealers particularly

    focus on the entity itself. These include requirements related to

    registration, capital, risk management, supervision, and chief

    compliance officers.\581\ Here too, an applicant for a limited purpose

    designation would have to demonstrate how it would satisfy those

    requirements in the context of limited designations.

    ---------------------------------------------------------------------------

    \581\ See, e.g., CEA section 4s(a)(1), Exchange Act section

    15F(a)(1) (registration requirements for dealers); CEA section

    4s(e), Exchange Act section 15F(e) (capital and margin requirements

    for dealers). The Dodd-Frank Act provides that in setting the

    capital requirements for swap dealers and security-based swap

    dealers (as well as major participants) that are subject to a

    limited designation, the Commissions and the prudential regulators

    must take into account the risks associated with other types,

    classes, or categories of swaps or security-based swaps engaged in,

    and the other swap or security-based swap activities conducted by,

    that person ``that are not otherwise subject to regulation

    applicable to that person by virtue of the status of the person'' as

    a dealer or major participant. See CEA section 4s(e)(2)(C); Exchange

    Act section 15F(e)(2)(C). In the case of a commercial agricultural

    or energy company that obtains a limited purpose designation for a

    particular business unit, the CFTC does not expect that this

    provision will generally require the limited purpose designee to

    calculate its required capital on the basis of swaps engaged in, or

    activities conducted by, other business units within the company, to

    the extent those swaps or activities do not generate risk beyond the

    agricultural or energy company's ordinary commercial line of

    business.

    ---------------------------------------------------------------------------

    A limited purpose designation might be appropriate, for example,

    where a commercial agricultural company is a dealer in swaps related to

    a thinly-traded commodity, such as a particular fertilizer, but is not

    a dealer in, and does not wish to be subject to the swap dealer

    requirements with respect to its swaps that relate to broadly-traded

    commodities like corn or wheat (or where, say, a commercial energy

    company is a dealer in swaps involving a commodity to be delivered at a

    particular location and does not wish to be subject to the swap dealer

    requirements for its swaps involving that commodity to be delivered at

    other locations, for which it is not a swap dealer). A limited

    designation might also be appropriate so that the swap dealer

    requirements do not apply to interest rate or currency swaps that the

    agricultural or energy company enters into in managing its financial

    risk.

    [[Page 30646]]

    A limited purpose designee could be a particular business unit

    within a company. Additionally, a limited designation might be

    considered to ``split the desk'' by applying the swap dealer

    requirements solely to the designee's limited activities involving

    swaps not entered into for the purpose of hedging a physical position

    as defined in CFTC Regulation Sec. 1.3(ggg)(6)(iii). Any particular

    limited purpose application will be analyzed in light of the unique

    circumstances presented by the applicant.

    A key challenge that any applicant to a limited dealer designation

    will face is the need to demonstrate full compliance with the

    requirements that apply to the type, class or category of swap or

    security-based swap, or the activities involving swaps or security-

    based swaps, that fall within the swap dealer designation.

    III. Amendments to the Definition of Eligible Contract Participant

    A. Background

    The Dodd-Frank Act makes it unlawful for a person that is not an

    eligible contract participant (``ECP'') to enter into a swap other than

    on, or subject to the rules of, a DCM.\582\ In addition, section 763(e)

    of the Dodd-Frank Act makes it unlawful for a person to effect a

    transaction in a security-based swap with or for a person that is not

    an ECP unless the transaction is effected on a national securities

    exchange registered with the SEC.\583\ Moreover, section 768(b) of the

    Dodd-Frank Act makes it unlawful for a person to offer to sell, offer

    to buy or purchase, or sell a security-based swap to a person that is

    not an ECP unless a registration statement under the Securities Act of

    1933 (``Securities Act'') \584\ is in effect with respect to that

    security-based swap.\585\ These provisions mean that persons can engage

    in neither swaps nor security-based swaps transactions with persons

    that are not ECPs on SEFs, on security-based SEFs, or on a bilateral,

    off-exchange basis.

    ---------------------------------------------------------------------------

    \582\ In particular, section 723(a)(2) of the Dodd-Frank Act

    adds new subsection (e) to CEA section 2 (7 U.S.C. 2(e)), providing

    that ``[i]t shall be unlawful for any person, other than an eligible

    contract participant, to enter into a swap unless the swap is

    entered into on, or subject to the rules of, a board of trade

    designated as a contract market under section 5.''

    \583\ In particular, section 763(e) of the Dodd-Frank Act adds

    paragraph (l) to Exchange Act section 6 (15 U.S.C. 78f(l)),

    providing that ``[i]t shall be unlawful for any person to effect a

    transaction in a security-based swap with or for a person that is

    not an eligible contract participant, unless such transaction is

    effected on a national securities exchange registered pursuant to

    subsection (b).''

    \584\ 15 U.S.C. 77a et seq.

    \585\ In particular, section 768(b) of the Dodd-Frank Act adds

    paragraph (d) to Securities Act section 5 (15 U.S.C. 77e(d)),

    providing that ``[n]otwithstanding the provisions of section 3 or 4,

    unless a registration statement meeting the requirements of section

    10(a) is in effect as to a security-based swap, it shall be unlawful

    for any person, directly or indirectly, to make use of any means or

    instruments of transportation or communication in interstate

    commerce or of the mails to offer to sell, offer to buy or purchase

    or sell a security-based swap to any person who is not an eligible

    contract participant as defined in section 1a(18) of the Commodity

    Exchange Act (7 U.S.C. 1a(18)).'' The Commissions note that market

    participants must make the determination of ECP status with respect

    to the parties to transactions in security-based swaps and mixed

    swaps prior to the offer to sell or the offer to buy or purchase the

    security-based swap or mixed swap.

    ---------------------------------------------------------------------------

    The Dodd-Frank Act also amended the ECP definition by: \586\ (i)

    Providing that, for purposes of CEA sections 2(c)(2)(B)(vi) and

    2(c)(2)(C)(vii), the term ECP does not include a commodity pool in

    which any participant is not itself an ECP; (ii) raising the monetary

    threshold that governmental entities may use to qualify as ECPs, in

    certain situations, from $25 million in investments owned and invested

    on a discretionary basis to $50 million in investments owned and

    invested on a discretionary basis; \587\ and (iii) replacing the

    ``total asset'' standard for individuals to qualify as ECPs with an

    ``amounts invested on a discretionary basis'' standard.\588\

    ---------------------------------------------------------------------------

    \586\ See Sections 741(b)(10) and 721(a)(9) of the Dodd-Frank

    Act; see also Financial Regulatory Reform, A New Foundation:

    Rebuilding Financial Supervision and Regulation, available at http://www.treasury.gov/initiatives/Documents/FinalReport_web.pdf, at 48-

    49 (June 17, 2009).

    \587\ See CEA section 1a(18)(A)(vii), 7 U.S.C. 1a(18)(A)(vii).

    \588\ See CEA section 1a(18)(A)(xi), 7 U.S.C. 1a(18)(A)(xi). The

    Dodd-Frank Act did not amend the monetary thresholds for individuals

    to qualify as ECPs. As such, an individual can qualify as an ECP if

    such individual has amounts invested on a discretionary basis, the

    aggregate of which is in excess of (i) $10,000,000, or (ii)

    $5,000,000 if such individual also enters into the agreement,

    contract, or transaction in order to manage the risk associated with

    an asset owned or liability incurred, or reasonably likely to be

    owned or incurred, by such individual.

    ---------------------------------------------------------------------------

    Commodity pools may, among other things, enter into transactions

    involving foreign currency. ECP status is important for commodity pools

    that enter into the following types of foreign currency transactions

    (such commodity pools, ``Forex Pools''): (i) Off-exchange foreign

    currency futures; (ii) off-exchange options on foreign currency

    futures; (iii) off-exchange options on foreign currency; (iv) leveraged

    or margined foreign currency transactions; and (v) foreign currency

    transactions that are financed by the offeror, the counterparty or a

    person acting in concert with the offeror or counterparty on a similar

    basis.\589\ In some cases, discussed below in detail, if a Forex Pool

    does not satisfy the ECP definition applicable to commodity pools

    engaging in the types of foreign currency transactions noted above

    \590\ and it engages in these types of foreign currency transactions

    (such transactions, ``retail forex transactions'' and such commodity

    pools, ``Retail Forex Pools''), the transactions will be subject to a

    regulatory regime that imposes certain requirements and restrictions on

    the counterparties to the Retail Forex Pool, and, if the Retail Forex

    Pool engages in retail forex transactions other than with certain

    counterparties, on the commodity pool operator (``CPO'') who operates

    the Retail Forex Pool. These requirements and restrictions do not apply

    if the Forex Pool satisfies the ECP definition applicable to commodity

    pools engaging in the types of foreign currency transactions noted

    above.

    ---------------------------------------------------------------------------

    \589\ See CEA sections 2(c)(2)(B)(vi) and 2(c)(2)(C)(vii), 7

    U.S.C. 2(c)(2)(B)(vi) and 7 U.S.C. 2(c)(2)(C)(vii). In this context,

    the term ``off-exchange'' means other than on or subject to the

    rules of an organized exchange, as defined in CEA section 1a(37), 7

    U.S.C. 1a(37).

    \590\ See CEA section 1a(18)(A)(iv), 7 U.S.C. 1a(18)(A)(iv); see

    also CFTC Regulation Sec. 1.3(m)(5) (exporting the look-through

    language of CEA section 1a(18)(A)(iv) to CEA section 1a(18)(A)(v)).

    The Dodd-Frank Act amended the ECP definition to include a provision

    that specifically applies to Forex Pools engaging in these types of

    foreign currency transactions. See Section 741(b)(10) of the Dodd-

    Frank Act (adding a provision to CEA section 1a(18)(A)(iv), 7 U.S.C.

    1a(18)(A)(iv), stating ``provided, however, that for purposes of

    section 2(c)(2)(B)(vi) and section 2(c)(2)(C)(vii), the term

    `eligible contract participant' shall not include a commodity pool

    in which any participant is not otherwise an eligible contract

    participant.''). See part III.B below for a discussion of this

    provision. This provision applies only with respect to retail forex

    transactions. This means that a Retail Forex Pool, as defined above,

    that is not an ECP for retail forex transaction purposes could be an

    ECP for other transactions it enters into that are not retail forex

    transactions.

    ---------------------------------------------------------------------------

    The Commissions are adopting further definitions of the term

    ``eligible contract participant'' in the following six respects: (i)

    Generally prohibiting a Forex Pool from qualifying as an ECP if such

    Forex Pool directly enters into retail forex transactions \591\ and has

    one or more direct participants that are not ECPs; \592\ (ii)

    clarifying that, in determining whether a direct participant in a Forex

    Pool is an ECP, the indirect participants in the Forex Pool will not be

    considered unless such Forex Pool, a commodity pool holding a direct or

    indirect (through one or more intermediate tiers of pools) interest in

    [[Page 30647]]

    such Forex Pool, or any commodity pool in which such Forex Pool holds a

    direct or indirect interest has been structured to evade Subtitle A of

    Title VII of the Dodd-Frank Act; \593\ (iii) prohibiting a commodity

    pool from qualifying as an ECP unless it has total assets exceeding $5

    million and is operated by a person described in CEA section

    1a(18)(A)(iv)(II);\594\ (iv) explicitly including swap dealers,

    security-based swap dealers, major swap participants, and major

    security-based swap participants in the definition of ECP; (v)

    permitting a non-ECP to qualify as an ECP, with respect to certain

    swaps, based on the collective net worth of its owners, subject to

    several conditions, including that the owners are ECPs; and (vi)

    permitting a Forex Pool to qualify as an ECP notwithstanding that it

    has one or more direct participants that are not ECPs if the Forex Pool

    (a) is not formed for the purpose of evading regulation under CEA

    sections 2(c)(2)(B) or (C) or related rules, regulations or orders, (b)

    has total assets exceeding $10 million and (c) is formed and operated

    by a registered CPO or by a CPO who is exempt from registration as such

    pursuant to Sec. 4.13(a)(3). In addition, the Commissions are issuing

    interpretive guidance regarding the definition of ECP to correct an

    inaccurate statutory cross-reference with respect to the ability of

    government entities to qualify as ECPs under CEA section

    1a(18)(A)(vii).\595\ The Commissions also are issuing interpretive

    guidance with respect to the ECP status of Forex Pools whose

    participants are limited solely to non-U.S. persons and which are

    operated by CPOs located outside the United States, its territories or

    possessions.

    ---------------------------------------------------------------------------

    \591\ In many commodity pool structures, this is the master fund

    alone.

    \592\ But see note 652, infra, with respect to single level

    Forex Pools using retail forex transactions solely to hedge.

    \593\ Section 721(c) of the Dodd-Frank Act requires the CFTC to

    adopt a rule to further define the terms ``swap,'' ``swap dealer,''

    ``major swap participant,'' and ``eligible contract participant,''

    in order ``[t]o include transactions and entities that have been

    structured to evade'' subtitle A of Title VII (or an amendment to

    the CEA made by subtitle A).

    \594\ 7 U.S.C. 1a(18)(A)(iv)(II).

    \595\ 7 U.S.C. 1a(18)(A)(vii).

    ---------------------------------------------------------------------------

    The Commissions note that commenters raised interpretive and other

    issues related to the ECP definition that the Commissions may consider

    in the future.\596\

    ---------------------------------------------------------------------------

    \596\ These issues include: (i) The ECP status of jointly and

    severally liable borrowers and counterparties, non-ECPs guaranteed

    by ECPs, and non-ECP swap collateral providers; (ii) whether bond

    proceeds count toward the ``owns and invests on a discretionary

    basis $50,000,000 or more in investments'' element of the

    governmental ECP prong (CEA section 1a(18)(A)(vii), 7 U.S.C.

    1a(18)(A)(vii)); (iii) the relationship between the ECP and eligible

    commercial entity definitions for purposes of CEA section

    1a(18)(A)(vii), 7 U.S.C. 1a(18)(A)(vii); (iv) the scope of the

    ``proprietorship'' element of the entity prong of the ECP definition

    in CEA section 1a(18)(A)(v), 7 U.S.C. 1a(18)(A)(v) (which the

    Commissions are addressing to a limited extent in the discussion of

    the new line of business ECP category in part III.F, infra, and in

    Regulation Sec. 1.3(m)(7)(ii)(C) under the CEA); (v) the meaning of

    the new ``amounts invested on a discretionary basis'' element of the

    individual prong of the ECP definition (CEA section 1a(18)(A)(xi), 7

    U.S.C. 1a(18)(A)(xi)); (vi) whether persons can be ECPs in

    anticipation of receiving, but before they have, the necessary

    assets; and (vii) that swap dealers are not among the entities

    listed in CEA section 2(c)(2)(B)(i)(II), 7 U.S.C. 2(c)(2)(B)(i)(II),

    as acceptable counterparties to non-ECPs engaging in retail forex

    transactions.

    ---------------------------------------------------------------------------

    B. Commodity Pool Look-Through for Retail Forex Transactions

    1. Statutory Provisions

    Prior to the Dodd-Frank Act, clause (A)(iv) of the ECP definition

    provided that a commodity pool was an ECP if it had $5 million in total

    assets and was operated by a person regulated under the CEA, regardless

    of whether each participant in the commodity pool was itself an

    ECP.\597\ Section 741(b)(10) of the Dodd-Frank Act added a proviso to

    clause (A)(iv) \598\ stating that a Forex Pool will not qualify as an

    ECP, solely for purposes of CEA sections 2(c)(2)(B)(vi) or

    2(c)(2)(C)(vii) (i.e., retail forex transactions) if any participant in

    the Forex Pool is itself not an ECP.\599\

    ---------------------------------------------------------------------------

    \597\ Clause (A)(iv) of the pre-Dodd-Frank Act ECP definition

    also included a commodity pool operated by a foreign person

    performing a similar role or function as a person regulated under

    the CEA and subject as such to foreign regulation (regardless of

    whether the foreign person was itself an ECP).

    \598\ The proviso states ``provided, however, that for purposes

    of section 2(c)(2)(B)(vi) and section 2(c)(2)(C)(vii), the term

    `eligible contract participant' shall not include a commodity pool

    in which any participant is not otherwise an eligible contract

    participant.'' CEA section 1a(18)(A)(iv); 7 U.S.C. 1a(18)(A)(iv).

    \599\ See CEA section 1a(18)(A)(iv), 7 U.S.C. 1a(18)(A)(iv). In

    other words, the proviso in section 1a(18)(A)(iv) does not reference

    or implicate ECP status for purposes of (i) CEA section 2(e), 7

    U.S.C. 2(e) (which, as discussed above, permits non-ECPs to trade

    swaps only on or subject to the rules of a DCM); (ii) Securities Act

    section 5(d) (which, as discussed above, makes it unlawful for a

    person to offer to sell, offer to buy or purchase, or sell a

    security-based swap to a person that is not an ECP unless a

    registration statement under the Securities Act is in effect with

    respect to that security-based swap); or (iii) Exchange Act section

    6(l) (which as discussed above, makes it unlawful for a person to

    effect a transaction in a security-based swap with or for a person

    that is not an ECP unless the transaction is effected on a national

    securities exchange registered with the SEC). The look-through

    proviso does not expressly state that indirect participants, as well

    as direct participants, in the Forex Pool must be ECPs for the Forex

    Pool to be an ECP. But see notes 636 and 638, infra (discussing the

    authority for such an approach).

    ---------------------------------------------------------------------------

    Thus, for purposes of retail forex transactions, the Dodd-Frank Act

    imposed a requirement to ``look through'' a Forex Pool--meaning that

    ECP status would be limited to Forex Pools in which each participant is

    itself an ECP. This is important for two reasons. First, a Forex Pool

    that does not qualify as an ECP can enter into a retail forex

    transaction described in CEA section 2(c)(2)(B)(i)(I) only with one of

    the federally-regulated counterparties enumerated in CEA sections

    2(c)(2)(B)(i)(II)(aa) (U.S. financial institutions),\600\ (bb) (certain

    brokers, dealers and their associated persons),\601\ (cc) (certain

    futures commission merchants (``FCMs'') and their affiliated

    persons),\602\ (dd) (certain financial holding companies) \603\ or (ff)

    (certain retail foreign exchange dealers (``RFEDs'')) \604\ (each an

    ``Enumerated Counterparty'' and collectively ``Enumerated

    Counterparties''); the counterparty restriction does not apply to

    retail forex transactions described in CEA section 2(c)(2)(C)(i)(I)(bb)

    \605\ entered into by a Forex Pool that does not qualify as an ECP,

    though such transactions are subject to antifraud protections and

    related enforcement provisions if entered into with a

    [[Page 30648]]

    counterparty other than an Enumerated Counterparty described in CEA

    section 2(c)(2)(B)(i)(II)(aa), (bb) or (dd).\606\ Second, the operator

    of a Retail Forex Pool engaging in retail forex transactions with an

    Enumerated Counterparty that is an FCM, specified affiliated person of

    an FCM or RFED must register with the CFTC as a CPO,\607\ unless the

    CPO also is an Enumerated Counterparty under 2(c)(2)(B)(i)(II)(aa),

    (bb) or (dd) \608\ or an exemption from CPO registration applies.\609\

    Moreover, CEA section 2(c)(2)(E)(ii)(I),\610\ which was added by

    section 742(c)(2) of the Dodd-Frank Act, prohibits an Enumerated

    Counterparty from entering into retail forex transactions described in

    CEA section 2(c)(2)(B)(i)(I) with a person that is not an ECP ``except

    pursuant to a rule or regulation of [the appropriate Federal regulator

    of such Enumerated Counterparty allowing such transactions] under such

    terms and conditions as [such regulator] shall prescribe.'' CEA section

    2(c)(2)(E)(iii)(II) \611\ requires that such rules or regulations treat

    similarly all agreements, contracts, and transactions in foreign

    currency that are functionally or economically similar to CEA section

    2(c)(2)(B)(i)(I) agreements, contracts, and transactions.

    ---------------------------------------------------------------------------

    \600\ 7 U.S.C. 2(c)(2)(B)(i)(II)(aa). The term ``financial

    institution'' is defined in CEA Section 1a(21), 7 U.S.C. 1a(21).

    \601\ 7 U.S.C. 2(c)(2)(B)(i)(II)(bb). This category is comprised

    of each:

    (AA) [] broker or dealer registered under section 15(b) (except

    paragraph (11) thereof) or 15C of the Securities Exchange Act of

    1934 (15 U.S.C. 78o(b), 78o-5); [and] (BB) [ ] associated person of

    a broker or dealer registered under section 15(b) (except paragraph

    (11) thereof) or 15C of the Securities Exchange Act of 1934 (15

    U.S.C. 78o(b), 78o-5) concerning the financial or securities

    activities of which the broker or dealer makes and keeps records

    under section 15C(b) or 17(h) of the Securities Exchange Act of 1934

    (15 U.S.C. 78o-5(b), 78q(h)).

    \602\ 7 U.S.C. 2(c)(2)(B)(i)(II)(cc). This category is comprised

    of each:

    (cc)(AA) []futures commission merchant that is primarily or

    substantially engaged in the business activities described in

    section 1a of this Act, is registered under this Act, is not a

    person described in item (bb) of this subclause, and maintains

    adjusted net capital equal to or in excess of the dollar amount that

    applies for purposes of clause (ii) of this subparagraph; [and] (BB)

    [ ] affiliated person of a futures commission merchant that is

    primarily or substantially engaged in the business activities

    described in section 1a of this Act, is registered under this Act,

    and is not a person described in item (bb) of this subclause, if the

    affiliated person maintains adjusted net capital equal to or in

    excess of the dollar amount that applies for purposes of clause (ii)

    of this subparagraph and is not a person described in such item

    (bb), and the futures commission merchant makes and keeps records

    under section 4f(c)(2)(B) of this Act concerning the futures and

    other financial activities of the affiliated person.

    \603\ 7 U.S.C. 2(c)(2)(B)(i)(II)(dd). The enumerated

    counterparty in this category is ``a financial holding company (as

    defined in section 2 of the Bank Holding Company Act of 1956).''

    \604\ 7 U.S.C. 2(c)(2)(B)(i)(II)(ff). This category is comprised

    of each:

    retail foreign exchange dealer that maintains adjusted net

    capital equal to or in excess of the dollar amount that applies for

    purposes of clause (ii) of this subparagraph and is registered in

    such capacity with the [CFTC], subject to such terms and conditions

    as the [CFTC] shall prescribe, and is a member of a futures

    association registered under section 17 [of the CEA].

    \605\ 7 U.S.C. 2(c)(2)(C)(i)(I)(bb).

    \606\ The counterparty limitation with respect to CEA section

    2(c)(2)(B)(i)(I) retail forex transactions is a function of the fact

    that the CEA's exchange-trading requirement generally applies with

    respect to foreign currency futures, foreign currency options on

    futures, and foreign currency options. See CEA section 4(a), 7

    U.S.C. 6(a) (generally requiring futures contracts to be traded on

    or subject to the rules of a DCM); CEA section 4c(b), 7 U.S.C. 6c(b)

    (prohibiting trading options subject to the CEA contrary to CFTC

    rules, regulations or orders permitting such trading); Part 32 of

    the CFTC's rules, 17 CFR part 32 (generally prohibiting entering

    into options subject to the CEA) and CFTC Regulation Sec. 33.3(a),

    17 CFR 33.3(a) (prohibiting entering into options on futures other

    than on or subject to the rules of a DCM). Because CEA section 4(a)

    would render an off-exchange futures contract illegal but for CEA

    section 2(c)(2)(B) permitting such transactions with an Enumerated

    Counterparty, it would be illegal for a non-Enumerated Counterparty

    to enter into a futures contract described in 2(c)(2)(B)(i)(I) with

    a non-ECP. Similarly, because options can be conducted only pursuant

    to CFTC authority and the CFTC has proposed to treat commodity

    options within its jurisdiction as swaps, CEA section 2(e) would

    prohibit such options, if on foreign exchange and entered into with

    a non-ECP, but for the fact that 2(c)(2)(B) permits them if traded

    with an Enumerated Counterparty.

    The lack of a counterparty limitation with respect to CEA

    section 2(c)(2)(C)(i)(I)(bb) retail forex transactions is a function

    of the different structures of CEA sections 2(c)(2)(B) and (C).

    Whereas CEA section 2(c)(2)(B)(i) covers transactions that would be

    illegal but for compliance with CEA section 2(c)(2)(B) (due to such

    section's incorporation of the entire CEA, including, for example,

    the exchange-trading requirement discussed above), falling within

    CEA section 2(c)(2)(C)(i)(I), by that section's own terms, merely

    brings a covered transaction within the scope of CEA section

    2(c)(2)(C), which does not include the exchange-trading requirement

    of CEA section 4(a). Because CEA section 2(c)(2)(C)(i)(I) covers

    transactions that may or may not also be transactions described in

    section 2(c)(2)(B)(i)(I) and the far fewer requirements imposed by

    CEA section 2(c)(2)(C) invite characterization of such difficult-to-

    categorize transactions as falling solely within CEA section

    2(c)(2)(C), the CFTC will interpret such dually characterizable

    transactions as governed by CEA section 2(c)(2)(B). If such

    transactions fall only within CEA section 2(c)(2)(C), however,

    because they would be subject to neither the exchange-trading

    requirement of CEA section 4(a) nor the CFTC's plenary options

    authority under CEA section 4c(b) (while CEA section

    2(c)(2)(C)(ii)(I), 7 U.S.C. 2(c)(2)(C)(ii)(I), reserves the CFTC's

    section 4c(b) authority, in this scenario, the contract in question

    is not an option), a person other than an Enumerated Counterparty

    may act as counterparty to a non-ECP. Such contracts would, however,

    be subject to two of the CEA's antifraud provisions, sections 4(b)

    and 4b, 7 U.S.C 6(b) and 7 U.S.C 6b, respectively, as if they were

    futures contracts. See CEA section 2(c)(2)(C)(iv), 7 U.S.C.

    2(c)(2)(C)(iv). Such contracts also would be subject to related

    enforcement provisions. See CEA section 2(c)(2)(C)(ii)(I), 7 U.S.C.

    2(c)(2)(C)(ii)(I).

    \607\ See CEA sections 2(c)(2)(B)(iv)(I) and (C)(iii)(I)

    (requiring registration for CPOs of Retail Forex Pools entering into

    retail forex transactions with FCMs, specified affiliated persons

    thereof or RFEDs). By contrast, those sections exclude from the CPO

    registration requirement CPOs of Retail Forex Pools engaging in

    retail forex transactions with Enumerated Counterparties described

    in CEA section 2(c)(2)(B)(i)(II)(aa), (bb), (ee) and (ff). While the

    cited CEA sections refer to counterparties not described in ``any of

    item (aa), (bb), (ee), or (ff)'' of subparagraph (B)(i)(II), the

    CFTC Reauthorization Act of 2008 (``CRA''), included as Title XIII

    of the Food, Conservation and Energy Act of 2008, Pub.L. 110-246,

    122 Stat. 1651 changed item (ee) to item (dd) (a financial holding

    company as defined in section 2 of the Bank Holding Company Act of

    1956) and removed item (ff) (formerly an investment bank holding

    company (as defined in section 17(i) of the Exchange Act (15 U.S.C.

    78q(i))). Therefore, the Commissions interpret the reference in CEA

    sections 2(c)(2)(B)(iv)(I)(cc) and 2(c)(2)(C)(iii)(I)(cc) to items

    (aa), (bb), (ee), or (ff) to be references to items (aa), (bb) and

    (dd). Cf. Retail Foreign Exchange Transactions; Conforming Changes

    to Existing Regulations in Response to the Dodd-Frank Wall Street

    Reform and Consumer Protection Act, 76 FR 56103 (Sept. 12, 2011)

    (providing background on related incorrect internal references in

    CEA sections 2(c)(2)(B) and (C)). See also CFTC Regulation Sec.

    5.3(a)(2)(i), 17 CFR 5.3(a)(2)(i), which requires a CPO, as defined

    in CFTC Regulation Sec. 5.1(d)(1), 17 CFR 5.1(d)(1), to register as

    such. CFTC Regulation Sec. 5.1(d)(1), in turn, defines a CPO, for

    purposes of Part 5 of the CFTC's Regulations, 17 CFR part 5, as

    ``any person who operates or solicits funds, securities or property

    for a pooled investment vehicle that is not an [ECP] as defined in

    section 1a(18) of the Act, and that engages in retail forex

    transactions.'' The CFTC interprets the references in Regulation

    Sec. 5.1(d)(1) to ECPs as defined in CEA section 1a(18) to include

    the ECP definition as further defined or interpreted by the

    Commissions under authority conferred by the Dodd-Frank Act or

    otherwise amended or interpreted by the Commissions or a court.

    While the statutory CPO definition in CEA section 1a(11)(A), 7

    U.S.C. 1a(11)(A), does not include transactions described in CEA

    section 2(c)(2)(B)(i), the Commissions believe this was an

    oversight. In any case, CEA section 1a(11)(B), 7 U.S.C. 1a(11)(B),

    grants the CFTC the authority to further define the term CPO, which

    the CFTC has done in CFTC Regulation Sec. 5.1(d)(1). Therefore, a

    person operating a commodity pool engaging in transactions described

    in CEA section 2(c)(2)(B)(i) is a CPO.

    \608\ See CEA sections 2(c)(2)(B)(iv)(II) and

    2(c)(2)(C)(iii)(II). While CEA sections 2(c)(2)(B)(iv)(II) and

    2(c)(2)(C)(iii)(II) refer to counterparties described in item (aa),

    (bb), (ee), or (ff) of subparagraph (B)(i)(II), the CFTC

    Reauthorization Act of 2008 changed item (ee) to item (dd) and

    removed item (ff). Therefore, the Commissions interpret the

    reference in CEA sections 2(c)(2)(B)(iv)(II) and 2(c)(2)(C)(iii)(II)

    to items (aa), (bb), (ee), or (ff) to be references to items (aa),

    (bb) and (dd). Cf. Retail Foreign Exchange Transactions; Conforming

    Changes to Existing Regulations in Response to the Dodd-Frank Wall

    Street Reform and Consumer Protection Act, 76 FR 56103 (Sept. 12,

    2011) (providing background on related incorrect internal references

    in 2(c)(2)(B) and (C)).

    \609\ See, e.g., CFTC Regulation Sec. 4.13(a)(3) (exempting

    from CPO registration operators of commodity pools engaged in a de

    minimis amount of trading in CFTC-jurisdictional contracts).

    \610\ 7 U.S.C. 2(c)(2)(E)(ii)(I).

    \611\ 7 U.S.C. 2(c)(2)(E)(iii)(II).

    ---------------------------------------------------------------------------

    Separately, subclause (A)(v)(III) of the ECP definition, both

    before and after enactment of the Dodd-Frank Act, provides that a

    corporation, partnership, proprietorship,\612\ organization, trust or

    other business entity may qualify as an ECP if it has a net worth

    exceeding $1 million and ``enters into an agreement, contract, or

    transaction in connection with the conduct of the entity's business or

    to manage the risk associated with an asset or liability owned or

    incurred or reasonably likely to be owned or incurred by the entity in

    the conduct of the entity's business.'' \613\

    ---------------------------------------------------------------------------

    \612\ Individuals also are covered by a different prong of the

    ECP definition. An individual can qualify as an ECP under clause

    (A)(xi) of the ECP definition. See CEA section 1a(18)(A)(xi), 7

    U.S.C. 1a(18)(A)(xi).

    \613\ There are two other ways a person can qualify as an ECP

    under clause (A)(v): (i) being an entity with total assets exceeding

    $10 million; or (ii) being an entity the obligations of which under

    an agreement, contract, or transaction are guaranteed or otherwise

    supported by a letter of credit or keepwell, support, or other

    agreement by an entity with total assets exceeding $10 million or an

    entity described in clause (A)(i), (ii), (iii), (iv) or (vii), or

    paragraph (C), of the ECP definition. See CEA section

    1a(18)(A)(v)(I) and (II), 7 U.S.C. 1a(18)(A)(v)(I) and (II),

    respectively.

    ---------------------------------------------------------------------------

    2. Proposed Approach

    The Commissions stated in the Proposing Release that ``in some

    cases commodity pools unable to satisfy the conditions of clause

    (A)(iv) of the ECP definition may rely on clause (A)(v) to qualify as

    ECPs instead for purposes of retail forex'' and that permitting such

    reliance would frustrate the intent of Congress in imposing the look-

    through requirement on Forex Pools in clause (A)(iv) of the ECP

    definition.\614\

    ---------------------------------------------------------------------------

    \614\ Proposing Release, 75 FR at 80185.

    ---------------------------------------------------------------------------

    The Commissions proposed to further define the term ``eligible

    contract participant'' to preclude a Forex Pool from qualifying as an

    ECP for purposes of retail forex transactions in reliance on clause

    (A)(v) of the ECP definition if

    [[Page 30649]]

    such Forex Pool has any participant that is not an ECP and, therefore,

    is not an ECP due to the look-through provision added to clause

    (A)(iv). Further, because commodity pools can be structured in various

    ways and can have one or more feeder funds and/or pools, the

    Commissions proposed to preclude a Forex Pool from being an ECP for

    purposes of retail forex transactions if there was any non-ECP

    participant at any level of the pool structure (e.g., the pool itself,

    a direct participant that invests in the pool, or any indirect

    participant that invests in that pool through other pools or vehicles).

    3. Commenters' Views

    One commenter supported the Commissions' efforts to close the

    potential loophole of Forex Pools that are unable to qualify as ECPs

    due to the new look-through provision in clause (A)(iv) of the ECP

    definition instead qualifying as ECPs under clause (A)(v) of the ECP

    definition.\615\ This commenter indicated that it shares the

    Commissions' concern that Forex Pools that do not satisfy the amended

    ECP definition due to the look-through provision for commodity pools in

    clause (A)(iv) may alternatively rely upon clause (A)(v) of the ECP

    definition to qualify as an ECP for purposes of retail forex

    transactions.\616\ This commenter further stated that Congressional

    intent in requiring a look-through for Forex Pools would be frustrated

    if fraudulent pool operators could avail themselves of this

    alternative.\617\

    ---------------------------------------------------------------------------

    \615\ See letter from the NFA. The NFA indicated that it

    recently took separate emergency actions against two firms that did

    not qualify under the NFA's requirements for retail forex

    transactions. In one case, the commodity pool fell short of the $5

    million total asset requirement in clause (A)(iv) of the ECP

    definition; in the other case, the firm never properly formed a

    commodity pool. The NFA cautioned in its letter, ``these cases

    illustrate that firms will attempt to obtain ECP status to shield

    themselves from the jurisdiction of regulators to the detriment of

    pool participants.''

    \616\ Id.

    \617\ Id.

    ---------------------------------------------------------------------------

    However, several commenters recognized the importance of the

    concern about a potential loophole \618\ but stated that the

    Commissions should revise the proposal to mitigate the potential

    adverse consequences to market participants. One commenter, for

    example, commented on the expected effects of the proposed rule on

    funds of funds (``FOFs'').\619\ According to this commenter, FOFs (i)

    normally face as counterparties foreign subsidiaries of U.S. banks and

    foreign banks, and (ii) would incur substantial counterparty,

    documentation and operational costs in moving their retail forex

    transactions onto DCMs or toward the Enumerated Counterparties.

    ---------------------------------------------------------------------------

    \618\ See, e.g., letters from SIFMA--AMG dated September 15,

    2011 (``SIFMA AMG IV'') (acknowledging some form of ECP look-through

    is appropriate to prevent evasion where circumvention otherwise

    could occur and stating that it is sympathetic to the Commissions'

    implicit objective of ensuring that a person that would not qualify

    as an ECP not be permitted to accomplish indirectly what it is not

    permitted to do directly), Sidley Austin LLP (``Sidley'') (stating

    that the commenter fully appreciates that Congress added the look-

    through language to the ECP definition to prevent unscrupulous forex

    market participants from avoiding the retail forex provisions of the

    CEA and the CFTC's rules by ``engineering'' an ECP by pooling the

    capital of a large group of retail customers, thus depriving those

    investors of the protections otherwise afforded to them), AIMA I

    (stating that ``we understand Congress has made a decision to try to

    protect retail investors by amending the definition of ECP under

    Section 1a(1[8]) of the [CEA] to include that, for a commodity pool

    to qualify as an ECP under sub-section (A)(iv), the pool's

    underlying participants must also qualify as ECPs under section

    1a(1[8])).''

    \619\ See letter from Sidley. Sidley noted that FOF managers'

    retail forex transactions are largely undertaken for hedging

    purposes and that most FOF managers offer investments to non-U.S.

    persons, a significant number of which pay for their investments in

    FOF interests using their own currency. Sidley further noted that,

    because most FOFs accept investments only in U.S. dollars, FOF

    managers must convert to U.S. dollars the foreign currency received

    from such investors and invest those dollars in underlying funds,

    and that they enter into a hedging transaction to reduce the risk of

    exchange rate changes between an investor's currency and the U.S.

    dollar.

    ---------------------------------------------------------------------------

    In a similar vein, two commenters advised that a substantial number

    of hedge funds, as well as publicly offered commodity pools, would,

    under the Commissions' proposal, fail to qualify as ECPs for purposes

    of retail forex transactions, as most such funds have at least one

    direct or indirect non-ECP participant.\620\ These commenters indicated

    that this would disrupt the trading strategies employed by many

    commodity trading advisors (``CTAs'') on behalf of commodity

    pools.\621\ One of these commenters suggested an anti-evasion approach

    combining a lower level of pool assets with a requirement that the

    commodity pool not be formed for the purpose of evading the regulatory

    requirements applicable to retail forex transactions.\622\

    ---------------------------------------------------------------------------

    \620\ See letters from Willkie Farr & Gallagher LLP (``Willkie

    Farr'') and the NYCBA Committee.

    \621\ Id.

    \622\ See letter from Willkie Farr.

    ---------------------------------------------------------------------------

    Another commenter argued that Congress did not include the look-

    through provision in clause (A)(v) of the ECP definition because of its

    effect on bona fide hedgers.\623\ This commenter also advised that the

    primary entities affected are hedge fund and private equity fund

    managers investing in securities who use retail forex transactions

    solely to hedge investment portfolio currency risks, and/or because

    they accept subscriptions in currencies other than U.S. dollars.\624\

    ---------------------------------------------------------------------------

    \623\ See letter from Akin Gump Strauss Hauer & Feld LLP (``Akin

    Gump'').

    \624\ Id.

    ---------------------------------------------------------------------------

    Several commenters disagreed with the Commissions' statement in the

    proposal that extending the look-through provision in clause (A)(iv) of

    the ECP definition to clause (A)(v) would effectuate Congressional

    intent. Two commenters noted that there is no specific Dodd-Frank Act

    provision requiring such a change.\625\ Two other commenters argued

    that clause (v) of the ECP definition provides an independent basis for

    qualification as an ECP, which should not be affected by the changes in

    clause (A)(iv) of the ECP definition.\626\

    ---------------------------------------------------------------------------

    \625\ See letters from AIMA I and Ropes & Gray LLP (``Ropes &

    Gray'').

    \626\ See letters from Akin Gump, Sidley and Skadden, Arps,

    Slate, Meagher & Flom LLP (``Skadden''). Sidley also indicated that

    there seems to be no compelling reason to treat commodity pools

    worse than other sophisticated market participants with respect to

    retail forex transactions with non-Enumerated Counterparties, and no

    reason to treat them worse than a corporation or other entity with

    only $10 million in total assets that therefore qualifies as an ECP

    under clause (A)(v) of the ECP definition to trade retail forex

    transactions although it may have no particular expertise in such

    markets.

    ---------------------------------------------------------------------------

    One commenter indicated that the extraterritorial application of

    the proposed rules regarding the ECP definition is unclear.\627\ Among

    other things, this commenter indicated it is unnecessary to extend the

    scope of the look-through to protect possible retail investors outside

    of the U.S., especially where a CPO has not marketed a pool in the U.S.

    and does not otherwise have any U.S. investors.\628\

    ---------------------------------------------------------------------------

    \627\ See letter from AIMA I.

    \628\ Id.

    ---------------------------------------------------------------------------

    Commenters proposed several alternative approaches that they

    believed would address the Commissions' concerns. One commenter

    suggested that the Commissions create a new category of ECPs for Forex

    Pools comprised entirely of qualified eligible persons (``QEPs'') \629\

    and operated by persons subject to regulation under the CEA.\630\ This

    commenter also suggested that the Commissions create a new category of

    ECPs for Forex Pools that satisfy a monetary threshold for total assets

    or for the minimum initial investment of a Forex Pool to be

    sufficiently large that, in general, only legitimate pools would exceed

    such thresholds.\631\ Finally, this commenter suggested that the

    Commissions create a category of ECPs

    [[Page 30650]]

    for non-U.S. persons.\632\ A second commenter suggested that the

    Commissions create a category of ECPs for commodity pools that are

    operated by a CPO or advised by a CTA subject to regulation by a

    foreign regulator comparable to the CFTC.\633\

    ---------------------------------------------------------------------------

    \629\ The term ``qualified eligible person'' is defined in CFTC

    Regulation Sec. Sec. 4.7(a)(2) and (3).

    \630\ See letter from Sidley.

    \631\ Id.

    \632\ Id. Sidley cited to the approach in Regulation S under the

    Securities Act (17 CFR 230.901 et seq.), Sections 3(c)(1) and (7) of

    the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)(1) and (7)),

    and CFTC Regulation Sec. 4.7(a)(2)(xi).

    \633\ See letter from Willkie Farr.

    ---------------------------------------------------------------------------

    One commenter suggested (i) allowing commodity pools and their

    counterparties to rely, for the duration of an investment and each time

    commodity pool participants make an investment decision, on participant

    ECP representations provided in connection with an initial investment,

    provided that each participant covenants to update such representations

    if they become inaccurate, and (ii) providing specific relief for FOFs

    because they generally invest all or substantially all of their assets

    in underlying portfolio funds and use retail forex transactions to

    reduce foreign exchange exposure.\634\

    ---------------------------------------------------------------------------

    \634\ See letter from Sidley.

    ---------------------------------------------------------------------------

    4. Final Rule

    After considering commenters' concerns, the Commissions are

    adopting final rules that have been revised from the proposal. In

    particular, consistent with the statutory text of the Dodd-Frank Act,

    CFTC Regulation Sec. 1.3(m)(5)(i) further defines the term ``eligible

    contract participant'' to prohibit a Forex Pool that directly enters

    into a retail forex transaction (i.e., a transaction-level commodity

    pool) \635\ from qualifying as an ECP under clause (A)(iv) or clause

    (A)(v) of the ECP definition, solely for purposes of entering into

    retail forex transactions, if the pool has one or more direct

    participants that are not ECPs. In response to commenters' concerns

    described above, CFTC Regulation Sec. 1.3(m)(5)(ii) is revised to

    provide that, in determining whether a commodity pool that is a direct

    participant in a transaction-level Forex Pool is an ECP, the indirect

    participants in the transaction-level Forex Pool \636\ will not be

    considered unless such Forex Pool, a commodity pool holding a direct or

    indirect (through one or more intermediate tiers of pools) interest in

    such Forex Pool, or any commodity pool in which such Forex Pool holds a

    direct or indirect interest has been structured to evade Subtitle A of

    Title VII of the Dodd-Frank Act by permitting persons that are not ECPs

    to participate in agreements, contracts, or transactions described in

    section 2(c)(2)(B)(i) or section 2(c)(2)(C)(i) of the Commodity

    Exchange Act. That is, absent evasion, the Commissions are changing the

    proposed ``indefinite look-through'' to an ``evasion-based look-

    through'' in the final rule.\637\

    ---------------------------------------------------------------------------

    \635\ Commodity pool structures can take various forms. One

    common commodity pool structure is a ``master-feeder'' fund

    structure. In such a structure, investors purchase interests in

    ``feeder funds,'' which in turn purchase interests in a ``master

    fund.'' Typically, the only fund in a commodity pool structure that

    enters into retail forex transactions (and other transactions)

    directly is the master fund; the feeder funds (and their investors)

    typically would participate indirectly by receiving the profit or

    loss from such retail forex transactions (and other transactions) as

    distributions based on the feeder funds' interests in the master

    fund. Notwithstanding that the master-feeder structure is common,

    other structures exist. Thus, each fund in a commodity pool

    structure that directly enters into retail forex transactions is a

    transaction-level commodity pool.

    \636\ A fund that does not itself engage in retail forex

    transactions but that holds an interest in a transaction-level Forex

    Pool that engages in retail forex transactions is itself a commodity

    pool. Cf. U.S. Regulation of the International Securities and

    Derivatives Markets--Greene, Beller, Rosen, Silverman, Braverman and

    Sperber, Sec. 12.13[1], n.351 and related text.

    \637\ The Commissions caution, however, that they will closely

    monitor developments in this part of the market and will not

    hesitate to revisit their decision to limit the look-through

    provision pursuant to 1.3(m)(5)(ii) should they observe a pattern of

    evasion or misconduct.

    ---------------------------------------------------------------------------

    In adding the look-through provision to the commodity pool prong of

    the ECP definition, Congress made a decision to protect retail foreign

    exchange investors by requiring that the participants in a Forex Pool

    qualify as ECPs for the Forex Pool itself to qualify as an ECP. The

    Commissions believe that the intent of the look-through provision--

    protecting Forex Pool participants from fraudulent and abusive

    conduct--must be given effect to comply with this Congressional

    mandate. Nevertheless, the Commissions acknowledge commenters' concerns

    about potential unintended consequences of applying an indefinite look-

    through to every direct and indirect participant of a Forex Pool, as

    proposed. Accordingly, to avoid unintended consequences and related

    costs for Forex Pools whose operators and managers have not

    historically presented the risks that the look-through provision was

    intended to address,\638\ the Commissions are replacing the proposed

    indefinite look-through of every participant in a Forex Pool with a

    limited, evasion-based look-through pursuant to which a transaction-

    level Forex Pool will qualify as an ECP, for purposes of retail forex

    transactions, if all of such Forex Pool's direct participants are ECPs,

    and will look through a commodity pool participant in such Forex Pool

    only if it, at any level, has been structured to evade the look-through

    provision in clause (A)(iv) of the ECP definition.

    ---------------------------------------------------------------------------

    \638\ The proposed rule was based on the CFTC's longstanding,

    broad view of what constitutes a ``pool,'' a view recently codified

    in the ``commodity pool'' definition by section 721(a)(5) of the

    Dodd-Frank Act in CEA section 1a(10), 7 U.S.C. 1a(10), and

    recognized by courts, and thus applied the look-through provision at

    each level of a Forex Pool's investment structure. See CFTC,

    Commodity Pool Operators and Commodity Trading Advisors: Amendments

    to Compliance Obligations, 77 FR 11252 (Feb. 24, 2012) (``CPO/CTA

    Compliance Release'') (advising that ``it is the position of the

    [CFTC] that a fund investing in an unaffiliated commodity pool it

    itself a commodity pool'' and ``[t]his interpretation is consistent

    with the statutory definition of commodity pool, which draws no

    distinction between direct and indirect investments in commodity

    interests''); CFTC v. Equity Financial Group, 572 F.3d 150, 157-158

    (July 13, 2009) (concluding, in the context of a commodity pool that

    invested all of its assets with a commodity pool operated by a

    different CPO, that the CFTC's commodity pool regulations ``cover

    pools that invest in other pools'' and that ``the remedial purposes

    of the statute would be thwarted if the operator of a fund could

    avoid the regulatory scheme simply by investing in another pool

    rather than trading''). The same logic applies to a master-feeder

    structure operated by the same CPO: the remedial purpose of the

    look-through proviso in clause (A)(iv) of the statutory ECP

    definition would be thwarted if the look-through could be defeated

    simply by funneling pool participants into a master fund through a

    feeder fund.

    The proposed rule also was borne of the CFTC's long history of

    combating fraudulent practices by typically unregistered individuals

    or entities that prey upon often unsophisticated retail customers

    through complex and highly leveraged off-exchange transactions in

    foreign currency. However, the operators and managers of commodity

    pool FOFs, master-feeder structures and hedge funds for

    sophisticated investors have not generally been the subject of CFTC

    enforcement actions with respect to retail forex transactions. For

    an in depth discussion of the history of the CFTC's authority over

    retail forex transactions, the abuses giving rise to that authority,

    and related enforcement actions, see CFTC, Regulation of Off-

    Exchange Retail Foreign Exchange Transactions and Intermediaries, 75

    FR 3282 (Jan. 20, 2010). Congress acted three times in a decade to

    clarify the CFTC's authority to prosecute the rampant fraud seen in

    this area--first in the Commodity Futures Modernization Act of 2000,

    Public Law 106-554, 114 Stat. 2763 (Dec. 21, 2000) in 2000, then

    again in the CRA, and finally in the Dodd-Frank Act in 2010.

    ---------------------------------------------------------------------------

    The Commissions believe the final rule strikes the right balance

    between implementing strong protections for non-ECP commodity pool

    participants and not imposing undue burdens or costs on CPOs, CTAs and

    commodity pool participants related to retail forex transactions. In

    addition, the Commissions believe that replacing the indefinite look-

    through with the limited, evasion-based look-through alleviates many of

    the commenters' concerns. Accordingly, the Commissions believe it is

    appropriate to limit the look-through provision to the level of a

    commodity pool structure that enters into retail forex transactions and

    to look through commodity pools to their ultimate participants only in

    those

    [[Page 30651]]

    cases in which it is required to prevent evasion of the protections for

    those persons whom Congress intended to be subject to retail forex

    transactions restrictions.

    At the same time, the Commissions do not believe that Forex Pools

    failing to qualify as ECPs due to the look-through provision in clause

    (A)(iv) of the ECP definition should, nonetheless, be permitted

    unfettered access to ECP status under clause (A)(v).\639\ The look-

    through provision for Forex Pools provides heightened investor

    protection from forex fraud for Forex Pool participants that are not

    themselves ECPs. Thus, the Commissions believe that permitting Forex

    Pools with one or more non-ECP participants to achieve ECP status by

    relying on clause (A)(v) of the ECP definition, which applies to

    business entities generally, would serve to undermine the look-through

    provision that Congress specifically imposed on Forex Pools under

    clause (A)(iv).\640\

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    \639\ In section 712(d)(2)(A) of the Dodd-Frank Act, Congress

    granted the Commissions the authority to adopt such rules regarding

    the ECP definition as the Commissions determine are necessary and

    appropriate, in the public interest, and for the protection of

    investors.

    \640\ The Commissions note that several commenters requested

    clarification regarding the relationship between the look-through

    provision set forth in CFTC Regulation Sec. 1.3(m)(5) and the

    prohibition on a commodity pool qualifying as an ECP under clause

    (A)(v) of the ECP definition if it does not qualify as an ECP under

    clause (A)(iv) of the ECP definition set forth in CFTC Regulation

    Sec. 1.3(m)(6). See, e.g., meeting with SIFMA--AMG on August 2,

    2011. The look-through provision is limited to determining ECP

    status under clause (A)(iv) or clause (A)(v) of the ECP definition

    for purposes of retail forex transactions entered into by Forex

    Pools. The look-through provision does not reference or implicate

    ECP status for purposes of CEA section 2(e) (which prohibits non-

    ECPs from entering into swaps other than on or subject to the rules

    of a DCM), Securities Act section 5(d) (which prohibits a person

    from offering to sell, offering to buy or purchase, or selling a

    security-based swap to a person that is a non-ECP unless a

    registration statement under the Securities Act is in effect with

    respect to that security-based swap), or Exchange Act section 6(l)

    (which prohibits a person from effecting a transaction in a

    security-based swap with or for a person that is a non-ECP unless

    the transaction is effected on a national securities exchange

    registered with the SEC). The prohibition in CFTC Regulation Sec.

    1.3(m)(6) on a commodity pool qualifying as an ECP under clause

    (A)(v) of the ECP definition if it does not qualify as an ECP under

    clause (A)(iv) of the ECP definition does not involve any look-

    through. Rather, in contrast with CFTC Regulation Sec. 1.3(m)(5),

    CFTC Regulation Sec. 1.3(m)(6) applies for purposes of all

    agreements, contracts and transactions for which ECP status is

    relevant. See part III.C, infra, for a discussion of the prohibition

    on a commodity pool qualifying as an ECP under clause (A)(v) of the

    ECP definition if it does not qualify as an ECP under clause (A)(iv)

    of the ECP definition.

    ---------------------------------------------------------------------------

    Moreover, developments subsequent to the issuance of the Proposing

    Release should ameliorate commenters' concerns that CEA section

    2(c)(2)(E)(ii)(I) significantly limits the universe of possible retail

    forex transaction counterparties.\641\ At the time the Commissions

    issued the Proposing Release and throughout the comment period, the

    CFTC was the only Federal regulatory agency that had issued final rules

    governing retail forex transactions by its regulated persons and

    entities.\642\ Since then, though, both the OCC and the FDIC finalized

    (effective July 15, 2011) rules governing retail forex transactions by

    Enumerated Counterparties regulated by those agencies.\643\ In

    addition, the SEC has issued interim temporary final rules (also

    effective July 15, 2011) governing retail forex transactions by

    registered broker-dealers.\644\ Also, the Federal Reserve Board

    proposed rules to govern retail forex transactions by its regulated

    banks on August 3, 2011.\645\ As a result of these regulatory actions,

    Forex Pools that are not ECPs due to the look-through provision and who

    are subject to a counterparty limitation \646\ may enter into retail

    forex transactions with any Enumerated Counterparty but for those

    regulated by the Federal Reserve Board.\647\

    ---------------------------------------------------------------------------

    \641\ See also part III.G, infra, discussing CFTC Regulation

    Sec. 1.3(m)(8), one effect of which is to eliminate the retail

    forex transaction counterparty restriction for Forex Pools

    qualifying as ECPs.

    \642\ See generally Part 5 of the CFTC's regulations, 17 CFR 5,

    and CFTC, Regulation of Off-Exchange Retail Foreign Exchange

    Transactions and Intermediaries, 75 FR 55410 (Sept. 10, 2010). See

    also CFTC, Retail Foreign Exchange Transactions; Conforming Changes

    to Existing Regulations in Response to the Dodd-Frank Wall Street

    Reform and Consumer Protection Act 76 FR 56103 (Sept. 12, 2011).

    \643\ See FDIC, Retail Foreign Exchange Transactions, 76 FR

    40779 (July 12, 2011) (final FDIC retail forex rules); OCC, Retail

    Foreign Exchange Transactions, 76 FR 41375 (July 14, 2011) (final

    OCC retail forex rules); see also OCC, Retail Foreign Exchange

    Transactions, 76 FR 56094 (Sept. 12, 2011) (interim final OCC retail

    forex rules for federal savings associations and their operating

    subsidiaries).

    \644\ See SEC, Retail Foreign Exchange Transactions, 76 FR 41676

    (July 15, 2011). In the release accompanying the rules, the SEC

    requested comment on broker-dealers' involvement in retail forex

    transactions to inform the SEC in developing permanent rules to

    regulate these activities. See id. at 46181-83.

    \645\ See Board, Retail Foreign Exchange Transactions

    (Regulation NN), 76 FR 46652 (Aug. 3, 2011) (proposed Board rules

    for retail forex transactions).

    \646\ See part III.B.1, supra, discussing the applicability of

    the counterparty limitation.

    \647\ Of course, upon the Board's finalization of its retail

    forex rules, U.S. financial institutions regulated by the Board also

    will be acceptable counterparties.

    ---------------------------------------------------------------------------

    The Commissions believe that the final rules reasonably address

    commenters' concerns. In this regard, the Commissions note that in

    applying the look-through provision, the Commissions will consider the

    indirect participants in a transaction-level Forex Pool if such Forex

    Pool, a commodity pool holding a direct or indirect (through one or

    more intermediate tiers of pools) interest in such Forex Pool, or any

    commodity pool in which such Forex Pool holds a direct or indirect

    interest has been structured to evade Subtitle A of Title VII of the

    Dodd-Frank Act by permitting persons that are not ECPs to participate

    in agreements, contracts, or transactions described in section

    2(c)(2)(B)(i) or section 2(c)(2)(C)(i) of the Commodity Exchange Act.

    One example of a scheme to evade would be if a commodity pool tier has

    been included in the structure of the Forex Pool primarily to provide

    non-ECP participants exposure to retail forex transactions rather than

    to achieve any other legitimate business purpose.\648\ One example of a

    ``legitimate business purpose'' that would not trigger the look-through

    provision is a FOF operated primarily for the purpose of investing in

    underlying funds and using retail forex transactions solely to hedge

    the currency risk posed by an unfavorable change in the exchange rate

    between the currency in which underlying funds accept investments and

    the currency in which FOF investors pay for their investments in the

    FOF.\649\ Similarly, the Commissions would not consider a commodity

    pool using retail forex transactions solely for bona fide hedging

    purposes \650\ with

    [[Page 30652]]

    respect to currency risk as being structured to avoid the look-through

    provision.\651\ The ``participate in agreements, contracts, or

    transactions described in section 2(c)(2)(B)(i) or section

    2(c)(2)(C)(i) of the Act'' language of CFTC Regulation Sec.

    1.3(m)(5)(ii) is aimed at exposure to retail forex transactions as an

    asset class, investment strategy, or an end in itself, not at exposure

    to retail forex transactions solely designed for bona fide hedging

    purposes with respect to foreign exchange exposure arising in the

    course of a commodity pool's business.\652\

    ---------------------------------------------------------------------------

    \648\ Feeder funds are usually added to commodity pool

    structures for purposes such as tax efficiency. A master-feeder

    structure ``[permits] U.S. taxable investors to take advantage of

    investing in a U.S. limited partnership feeder fund, which[,]

    through certain elections made at the time the structure is

    established, is tax effective for such U.S. taxable investors'' and

    ``[permits] [n]on-U.S. and U.S. tax-exempt investors [to] subscribe

    via a separate offshore feeder company so as to avoid coming

    directly within the U.S. tax regulatory net applicable to U.S.

    taxable investors.'' Effie Vasilopoulos & Katherine Abrat, The

    Benefits of Master-Feeder Fund Structures for Asian-based Hedge Fund

    Managers, Hedge Fund Monthly (April 2004), available at http://www.eurekahedge.com/news/04apr_archive_Sidley_master_feeder.asp.

    Other benefits can include efficiencies gained by the use of only a

    single trading entity, avoiding the need to split trade tickets,

    eliminating the need to duplicate agreements with counterparties and

    greater economies of scale in administering the fund. Id.

    \649\ Sidley notes that the typical FOF operates in this manner.

    See generally letter from Sidley for a more detailed discussion of

    these transactions.

    \650\ In this context, bona fide hedging purposes means bona

    fide hedging purposes within the meaning and intent of CFTC

    Regulation Sec. 1.3(z)(1), except that the requirement therein that

    the transaction or position be on a DCM or SEF that is a trading

    facility will not be a factor in the bona fide hedging purpose

    analysis. Compare CFTC Regulation Sec. 4.5(c)(2)(iii)(A) (relying

    in part on the bona fide hedging concepts in CFTC Regulations

    Sec. Sec. 1.3(z)(1) and 151.5 to provide relief from the CPO

    definition). See also CPO/CTA Compliance Release at 11256-11257

    (discussing and declining to adopt commenters' request to expand the

    definition of bona fide hedging to include risk management). Where a

    Forex Pool's counterparty, but not the Forex Pool, is hedging its

    risks, it is not the case that the Forex Pool is entering the retail

    forex transaction solely to hedge its own risk.

    \651\ The examples mentioned in text should not be construed to

    mean that any other fact pattern does or does not constitute

    evasion, which must be determined on a case-by-case basis.

    \652\ Based on the same reasoning, the Commissions do not

    believe it was the intent of the look-through proviso in CEA section

    1a(18)(A)(iv) to subject to a retail forex regime a single level

    commodity pool engaging in retail forex transactions solely for bona

    fide hedging purposes with respect to foreign exchange exposure

    arising in the course of a commodity pool's operations.

    Consequently, the Commissions will interpret such a commodity pool

    as an ECP if it otherwise satisfies the terms of CEA section

    1a(18)(A)(iv) even if such a pool has one or more non-ECP

    participants.

    ---------------------------------------------------------------------------

    In applying the limited look-through provision in the final rule,

    the Commissions would consider a Forex Pool's direct participants to

    include not only persons that initially hold interests in the level of

    the commodity pool structure that enters into retail forex

    transactions, but also persons that can acquire those interests or that

    subsequently hold those interests. As applied to exchange-traded

    products (``ETPs'') that are Forex Pools, any person that acquires an

    interest in the ETP Forex Pool in secondary market transactions would

    be a direct participant. ETPs typically issue shares only in the large

    aggregations or blocks (such as 50,000 ETP shares) called ``Creation

    Units.'' An authorized purchaser, usually an investment bank, broker

    dealer or large institutional investor, may purchase a Creation Unit.

    After purchasing a Creation Unit, the authorized purchaser may hold the

    Creation Unit, or sell some or all of the ETP shares in the Creation

    Unit to investors in secondary market transactions by splitting up the

    Creation Unit and selling the individual ETP shares on a national

    securities exchange or in off-exchange transactions. The ability to

    break up the Creation Unit into ETP shares permits other investors,

    such as non-ECPs, to purchase the individual ETP shares in secondary

    market transactions.

    All participants in an ETP Forex Pool must be ECPs when they

    purchase or otherwise acquire an interest in the ETP Forex Pool. In

    addition, an ETP Forex Pool will not be able to verify whether the

    persons that acquire interests in the ETP Forex Pool in exchange

    transactions are ECPs. The ability of non-ECPs to acquire interests in

    an ETP Forex Pool and the inability of the ETP Forex Pool to verify ECP

    status with respect to exchange transactions create a presumption that

    ETP Forex Pools are not ECPs and, therefore, are Retail Forex Pools.

    This presumption would not apply in the case of a Forex Pool that is

    structured in a manner that does not involve exchange trading and in

    which the Forex Pool would be able to verify the ECP status of its

    participants.

    One commenter suggested that the Commissions allow commodity pools

    and their counterparties to rely on participant ECP representations

    provided in connection with an initial investment.\653\ The Commissions

    note that the obligation to determine that the parties to retail forex

    transactions are ECPs is imposed on the CPOs of Forex Pools and the

    counterparties looking to enter into retail forex transactions with

    Forex Pools. In making that determination, the Commissions expect CPOs

    and retail forex transaction counterparties to Forex Pools to be guided

    by the principles for verifying the ECP status of a swap dealer's or

    major swap participant's counterparty discussed in the CFTC's recently

    adopted external business conduct standards, including the safe

    harbor.\654\ Thus, solely for purposes of CEA section 1a(18)(A)(iv) and

    CFTC Regulation Sec. 1.3(m)(5), the Commissions will permit CPOs and

    retail forex transaction counterparties to rely on written

    representations from, as applicable, pool participants or potential

    pool participants that the person making the representation is an ECP

    (or is a non-U.S. person; as discussed below in this section III.B.4.,

    solely for purposes of CEA section 1a(18)(A)(iv) and CFTC Regulation

    Sec. 1.3(m)(5), the Commissions will consider Forex Pools whose

    participants are limited solely to non-U.S. persons (and which are

    operated by CPOs located outside of the U.S., its territories or

    possessions) to be ECPs), or from Forex Pools that the Forex Pool is an

    ECP, provided that the CPO or retail forex transaction counterparty has

    a reasonable basis to so rely, just as swap dealers and major swap

    participants are permitted to do pursuant to the safe harbor in new

    CFTC Regulation Sec. 23.430(d), 17 CFR 23.430(d). Solely for purposes

    of CEA section 1a(18)(A)(iv) and CFTC Regulation Sec. 1.3(m)(5), a CPO

    or retail forex transaction counterparty will have a reasonable basis

    to rely on such written representations if the person making the

    representation specifies therein the provision(s) of, as applicable,

    section 1a(18) of the CEA or CFTC Regulation Sec. 4.7(a)(1)(iv)

    pursuant to which the person qualifies as an ECP or a non-U.S. person,

    respectively, unless it has information that would cause a reasonable

    person to question the accuracy of the representation.\655\ Solely for

    purposes of CEA section 1a(18)(A)(iv) and CFTC Regulation Sec.

    1.3(m)(5), persons representing that they qualify as non-U.S. persons

    based on CFTC Regulation Sec. 4.7(a)(1)(iv)(D) must represent that

    they are relying on such provision as modified as discussed below

    (i.e., without the 10% carve-out for U.S. persons).

    ---------------------------------------------------------------------------

    \653\ See letter from Sidley.

    \654\ See CFTC, Business Conduct Standards for Swap Dealers and

    Major Swap Participants With Counterparties; Final Rule, 77 FR 9733

    (Feb. 17, 2012).

    \655\ Cf. CFTC Regulation Sec. Sec. 23.430(d), 23.402(d).

    ---------------------------------------------------------------------------

    Furthermore, the CFTC recognizes that, despite a counterparty's

    reasonable good faith efforts to ensure that Forex Pools do not in fact

    have any U.S. participants, a situation may arise where a Forex Pool

    does turn out to have U.S. participants. If a counterparty has

    reasonable policies and procedures in place to verify the ECP status of

    Forex Pool counterparties and, notwithstanding such reasonable good

    faith efforts and following such policies and procedures, enters into

    retail forex transactions with such a Forex Pool in good faith and it

    was subsequently determined that U.S. participants represented no more

    than a de minimis number of participants or amount of ownership of the

    Forex Pool, absent other material factors, the CFTC would not expect to

    bring an enforcement action against the counterparty for entering into

    a retail forex transaction in contravention of the requirements of the

    retail forex regime. For purposes of this analysis only, and without

    this being viewed as a de minimis threshold for purposes of this rule

    or otherwise, the CFTC would consider as de minimis, ownership of units

    of participation of a Forex Pool held by U.S. participants of less than

    10% of the beneficial interest in the Forex Pool. The fact that, absent

    other material factors, the CFTC would not expect to bring an

    enforcement action against a forex transaction counterparty in such

    case does not

    [[Page 30653]]

    relieve any obligation on the part of the CPO of the Forex Pool either

    to register as a CPO, claim the 4.13(a)(3) exemption therefrom or

    redeem the U.S. participants as described above.

    One commenter suggested that the Commissions allow commodity pools

    and their counterparties to rely on participant ECP representations

    provided in connection with an initial investment.\656\ The Commissions

    believe that if participants make ECP representations in connection

    with an initial investment in a Forex Pool, absent an additional

    investment (which would require a new ECP verification, other than in

    the case of automatically reinvested distributions), the subsequent

    loss of a participant's ECP status would not cause the Forex Pool to

    lose its own ECP status for purposes of retail forex transactions so

    long as the operating agreement of the Forex Pool or the subscription

    or other agreement pursuant to which the participant invested in the

    Forex Pool requires the participant to advise the CPO of the Forex Pool

    promptly of a loss of the participant's ECP status. In the event of the

    loss of ECP status of a participant, the CPO would be required to

    redeem the non-ECP from the Forex Pool at the first opportunity

    following notification to avoid the Forex Pool losing its ECP status

    for subsequent retail forex transactions.

    ---------------------------------------------------------------------------

    \656\ See letter from Sidley. The Commissions note that the

    obligation to determine that the parties to retail forex

    transactions are ECPs is imposed on the CPOs of Forex Pools and the

    persons looking to engage in retail forex transactions with Forex

    Pools.

    ---------------------------------------------------------------------------

    The Commissions are mindful that several commenters indicated that

    CPOs do not customarily include a question or representation as to ECP

    status in subscription agreements for pool participants, and stated

    that requiring CPOs to qualify or redeem existing participants due to

    the new look-through provision would be expensive, burdensome and

    disruptive.\657\ In this regard, the Commissions note that the look-

    through requirement for commodity pools was imposed by statute. As a

    result of the Commissions adopting the limited look-through in the

    final rule (as compared to the proposed indefinite look-through),

    however, the number of commodity pools subject to the look-through

    provision should be dramatically reduced, reducing the number of pools

    subject to regulation of their retail forex transactions, and the

    associated costs, accordingly.\658\

    ---------------------------------------------------------------------------

    \657\ See, e.g., letter from SIFMA AMG IV.

    \658\ The adoption of CFTC Regulation Sec. 1.3(m)(8), discussed

    in part III.G, infra, also should reduce the number of pools subject

    to regulation of their retail forex transactions, and the associated

    costs, accordingly.

    ---------------------------------------------------------------------------

    Also, in response to commenter concerns that the look-through

    provision would be applied to entities other than commodity pools

    (e.g., operating companies),\659\ the Commissions revised the text of

    CFTC Regulation Sec. 1.3(m)(5)(i) to reflect their intent to apply the

    look-through provision solely to commodity pools qualifying as ECPs, if

    at all, under clause (A)(iv) and clause (A)(v) of the ECP

    definition.\660\ This is consistent with the statutory text, which is

    limited to looking through commodity pools under clause (A)(iv) of the

    ECP definition, and the intent behind the look-through provision, as it

    relates to clause (A)(v) thereof.

    ---------------------------------------------------------------------------

    \659\ See, e.g., letter from Sandalwood Securities, Inc.

    (expressing concern that ``the Proposed Rule extends Dodd-Frank's

    limited look-through provision to all sub-sections of section

    la(12)'').

    \660\ Thus, for example, investment companies qualifying under

    clause (A)(iii) of the ECP definition and employee benefit plans

    qualifying under clause (A)(vi) of the ECP definition (and, as

    stated in each clause, ``a foreign person performing a similar role

    or function subject as such to foreign regulation'') would not be

    covered by the look-through provision. To the extent that other

    entities would otherwise be captured by the look-through as proposed

    (such as collective investment trusts whose investors are ERISA

    plans not excluded from the commodity pool definition by CFTC

    Regulation Sec. 4.5(a)(4) and which qualify as ECPs under clause

    (A)(v) of the ECP definition), the Commissions believe that focusing

    on the level of the Forex Pool entering into the retail forex

    transactions, and such Forex Pool's direct participants (absent

    evasion), should alleviate such concerns.

    ---------------------------------------------------------------------------

    Commenters also stated that Retail Forex Pools will no longer be

    able to enter into retail forex transactions with foreign financial

    institutions.\661\ As discussed in section III.B.1. above, however,

    this is not the case with respect to retail forex transactions

    described in CEA section 2(c)(2)(C)(i)(I)(bb). With respect to retail

    forex transactions described in CEA section 2(c)(2)(B)i)(I), this is a

    consequence of the express statutory text of the Dodd-Frank Act, which

    removed non-U.S. financial institutions from the list of Enumerated

    Counterparties eligible to enter into retail forex transactions with

    non-ECPs.\662\

    ---------------------------------------------------------------------------

    \661\ Cf. letters from Sidley and Millburn Ridgefield

    Corporation (``Millburn'').

    \662\ See section 742(c) of the Dodd-Frank Act, amending CEA

    section 2(c)(2)(B)(i)(II)(aa), 7 U.S.C. 2(c)(2)(B)(i)(II)(aa).

    ---------------------------------------------------------------------------

    Commenters further suggested generally that the Commissions create

    additional categories of ECPs to address the Commissions' concerns

    regarding the potential loophole of Retail Forex Pools that are unable

    to qualify as ECPs due to the new look-through provision in clause

    (A)(iv) of the ECP definition qualifying as an ECP under clause (A)(v)

    of the ECP definition. While one commenter proposed adopting a new rule

    clarifying that Forex Pools comprised entirely of QEPs and operated by

    persons subject to regulation under the CEA are ECPs,\663\ Congress

    chose to look to ECP status of Forex Pool participants, not QEP status,

    as the basis for determining whether such Forex Pools are ECPs.

    Therefore, it is more appropriate to rely on Retail Forex Pool

    participants' ECP status than to rely on QEP status to establish ECP

    status.

    ---------------------------------------------------------------------------

    \663\ See letter from Sidley. This commenter also suggested

    deeming non-U.S. persons to be ECPs by definition. The Commissions

    have addressed this comment below in this section in response to the

    comment regarding the extraterritorial impact of the proposed ECP

    rules.

    ---------------------------------------------------------------------------

    One commenter stated a concern regarding what it characterized as

    the lack of clarity surrounding the extraterritoriality impact of the

    proposed ECP rules.\664\ The Commissions recognize the potential

    consequences of the broad look-through language in CEA section

    1a(18)(A)(iv) \665\ and are providing guidance as to the application of

    the look-through to Forex Pools whose participants are limited solely

    to non-U.S. persons and which are operated by CPOs located outside the

    United States, its territories or possessions.

    ---------------------------------------------------------------------------

    \664\ See letter from AIMA I.

    \665\ 7 U.S.C. 1a(18)(A)(iv).

    ---------------------------------------------------------------------------

    As discussed below, while foreign entities are not necessarily

    immune from U.S. jurisdiction for commercial activities undertaken with

    U.S. counterparties or in U.S. markets, canons of statutory

    construction ``assume that legislators take account of the legitimate

    sovereign interests of other nations when they write American laws,''

    \666\ particularly when limited U.S. interests are at stake.\667\

    ---------------------------------------------------------------------------

    \666\ See F. Hoffman-LaRoche, Ltd. v. Empagran S.A., 542 U.S.

    155, 164 (2004), citing Murray v. Schooner Charming Betsy, 2 Cranch

    64, 118, 2 L.Ed. 208 (1804) (``[A]n act of congress ought never to

    be construed to violate the law of nations if any other possible

    construction remains''); Hartford Fire Insurance Co. v. California,

    509 U.S. 764 (1993) (Scalia, J., dissenting). See also Restatement

    (Third) Foreign Relations Law Sec. 403 (scope of a statutory grant

    of authority must be construed in the context of international law

    and comity including, as appropriate, the extent to which regulation

    is consistent with the traditions of the international system).

    \667\ See also CFTC, Exemption From Registration for Certain

    Foreign Persons, 72 FR 63976 (Nov. 14, 2007) (where the CFTC stated

    that:

    Given this agency's limited resources, it is appropriate at this

    time to focus [the Commission's] customer protection activities upon

    domestic firms and upon firms soliciting or accepting orders from

    domestic users of the futures markets and that the protection of

    foreign customers of firms confining their activities to areas

    outside this country, its territories, and possessions may best be

    for local authorities in such areas)

    (citing CFTC, Introducing Brokers and Associated Persons of

    Introducing Brokers, Commodity Trading Advisors and Commodity Pool

    Operators; registration and Other Regulatory Requirements, 48 FR

    35248, 35261 (Aug. 3, 1983)).

    ---------------------------------------------------------------------------

    [[Page 30654]]

    The Commissions do not believe that Congress intended for Forex

    Pools with no U.S. participants and operated by CPOs located outside

    the United States, its territories or possessions to be subject to a

    U.S. retail forex regime and, therefore, will consider Forex Pools

    whose participants are limited solely to non-U.S. persons and which are

    operated by CPOs located outside the United States, its territories or

    possessions to be ECPs for purposes of CFTC Regulation Sec. 1.3(m)(5).

    For this purpose, a Forex Pool participant is a non-U.S. person if it

    satisfies the definition of ``Non-United States person'' in CFTC

    Regulation 4.7(a)(1)(iv); provided, however, that, if a participant is

    an entity organized principally for passive investment, such as a pool,

    investment company or other similar entity, such entity will be

    considered to be a Non-United States person under paragraph (D) of CFTC

    Regulation 4.7(a)(1)(iv) for purposes of CFTC Regulation Sec.

    1.3(m)(5) solely if all units of participation in such passive

    investment vehicle participant are held by Non-United States

    persons.\668\ A broader interpretation or relief is not appropriate at

    this time.\669\

    ---------------------------------------------------------------------------

    \668\ CFTC Regulation Sec. 4.7(a)(i)(iv)(D) lists the following

    as one category of non-United States person:

    An entity organized principally for passive investment such as a

    pool, investment company or other similar entity; Provided, That

    units of participation in the entity held by persons who do not

    qualify as Non-United States persons or otherwise as qualified

    eligible persons represent in the aggregate less than 10% of the

    beneficial interest in the entity, and that such entity was not

    formed principally for the purpose of facilitating investment by

    persons who do not qualify as Non-United States persons in a pool

    with respect to which the operator is exempt from certain

    requirements of part 4 of the Commission's regulations by virtue of

    its participants being Non-United States persons.

    It would be inappropriate to disregard the presence of U.S.

    persons constituting as much as 10% of such entities' participants

    in the context of this interpretive guidance. As discussed elsewhere

    herein, however, entities described in CEA section 1a(18)(A)(iii) or

    (vi), 7 U.S.C. 1a(18)(A)(iii) or (vi), are not subject to the look-

    through and are ECPs irrespective of the ECP status of their

    participants.

    \669\ Cf. CPO/CTA Compliance Release at 11264 (stating that ``it

    is prudent to withhold consideration of a foreign advisor exemption

    until the [CFTC] has received data regarding such firms on Forms

    CPO-PQR and/or CTA-PR * * * to enable the [CFTC] to better assess

    [which] firms * * * may be appropriate to include within the

    exemption, should the [CFTC] decide to adopt one'').

    ---------------------------------------------------------------------------

    C. ECP Status for Commodity Pools Under Clause (A)(v) vs. Under Clause

    (A)(iv) of the ECP Definition

    1. Proposed Approach

    The Commissions stated in the Proposing Release that they believe

    ``some commodity pools unable to satisfy the total asset or regulated

    status components of clause (A)(iv) of the ECP definition may rely on

    clause (A)(v) to qualify as ECPs instead.'' \670\ The Commissions

    further stated in the Proposing Release that ``a commodity pool that

    cannot satisfy the monetary and regulatory status conditions prescribed

    in clause (A)(iv) should not qualify as an ECP in reliance on clause

    (A)(v) of the ECP definition.'' \671\ Based on those views, the

    Commissions proposed to further define the term ``eligible contract

    participant'' to prevent such a commodity pool from qualifying as an

    ECP pursuant to clause (A)(v) of the ECP definition. This proposal

    applied to all commodity pools, not just Forex Pools engaged in retail

    forex transactions.

    ---------------------------------------------------------------------------

    \670\ Proposing Release, 75 FR at 80185.

    \671\ Id.

    ---------------------------------------------------------------------------

    2. Commenters' Views

    Two commenters argued that, had Congress wished to prevent

    commodity pools from relying on the general ECP provision for business

    entities in clause (A)(v), it could have expressly excluded commodity

    pools from clause (A)(v).\672\ Another commenter attempted to

    illustrate that clause (A)(v) of the ECP definition is an independent

    basis for qualifying as an ECP by distinguishing clause (A)(v) from

    clause (A)(iv).\673\

    ---------------------------------------------------------------------------

    \672\ See letters from Sidley and Skadden.

    \673\ See letter from Akin Gump. Akin Gump noted that ``[a]s

    opposed to [clause] (A)(iv), [clause] (A)(v) includes as one means

    of satisfying its criteria that the entity be entering into a

    contract for hedging purposes.'' While correct, clause (A)(v) also

    includes as another means of satisfying its criteria that an entity

    enter into agreements, contracts or transactions in connection with

    the conduct of the entity's business, which would be a much lower

    standard.

    ---------------------------------------------------------------------------

    One commenter expressed the view that it is unclear whether

    ``subject to regulation under this Act'' in CEA section

    1a(18)(A)(iv)(II) \674\ means a registered CPO or something else (e.g.,

    a person excluded from the definition of a CPO, a CPO exempt from

    registration conditioned in part upon making a filing to claim such

    relief).\675\

    ---------------------------------------------------------------------------

    \674\ 7 U.S.C. 1a(18)(A)(iv)(II).

    \675\ See letter from SIFMA AMG IV. CEA Section

    1a(18)(A)(iv)(II) refers to a commodity pool that ``is formed and

    operated by a person subject to regulation under this Act or a

    foreign person performing a similar role or function subject as such

    to foreign regulation (regardless of whether each investor in the

    commodity pool or the foreign person is itself an eligible contract

    participant) provided, however, that for purposes of section

    2(c)(2)(B)(vi) and section 2(c)(2)(C)(vii), the term `eligible

    contract participant' shall not include a commodity pool in which

    any participant is not otherwise an eligible contract participant.''

    ---------------------------------------------------------------------------

    3. Final Rule

    The Commissions are adopting CFTC Regulation Sec. 1.3(m)(6) as

    proposed, which states that ``[a] commodity pool that does not have

    total assets exceeding $5,000,000 or that is not operated by a person

    described in subclause (A)(iv)(II) of section 1a(18) of the Act is not

    an eligible contract participant pursuant to clause (A)(v) of such

    Section.'' \676\ As noted, the Commissions are concerned that clause

    (A)(v) of the ECP definition may undermine the protections that

    specifically apply to commodity pool participants pursuant to the

    limitations on ECP status for commodity pools set forth in clause

    (A)(iv) of the ECP definition. Allowing a commodity pool that cannot

    satisfy the monetary and regulatory status conditions prescribed for

    commodity pools in clause (A)(iv) to qualify as an ECP under clause

    (A)(v) would undermine these protections.

    ---------------------------------------------------------------------------

    \676\ The Commissions have made certain technical corrections to

    proposed CFTC Regulation Sec. 1.3(m)(6)(i) as concerns its

    citations to the CEA.

    ---------------------------------------------------------------------------

    The Commissions acknowledge the comments stating that clause (A)(v)

    of the ECP definition is an independent basis for qualifying as an ECP

    and that Congress did not explicitly provide that a commodity pool that

    fails to qualify as an ECP under clause (A)(iv) cannot do so under

    clause (A)(v). However, when specifically legislating for commodity

    pools, Congress determined that total assets of $5 million and

    operation by a person subject to regulation under the CEA (or a foreign

    equivalent) are necessary to assure appropriate protection for non-ECP

    participants in a commodity pool. Furthermore, the commenters' view

    that Congress's use of the disjunctive term ``or'' between clauses

    (A)(x) and (A)(xi) of the ECP definition means that an entity can rely

    on clause (A)(v) of the ECP definition, notwithstanding that such

    entity cannot satisfy a prong more specific to it, would largely render

    superfluous each clause under subparagraph (A) of the ECP definition

    other than clause (v) and clause (xi) (for individuals).\677\ As such,

    the Commissions believe that the final rule adopted in this release is

    consistent with Congressional intent.

    ---------------------------------------------------------------------------

    \677\ Interpreting statutory language as surplusage is

    disfavored. Effect should be given to every clause and word of a

    statute. See Negonsott v. Samuels, 507 U.S. 99 (1993).

    ---------------------------------------------------------------------------

    The Commissions also are mindful that one commenter expressed a

    concern that the Commissions' reliance on clause (A)(iv) of the ECP

    definition

    [[Page 30655]]

    might cause commodity pools to lose their ability to claim ECP status

    under clauses of the ECP definition, other than clause (v), and asked

    the Commissions to clarify the meaning of the phrase ``formed and

    operated by a person subject to regulation under the [CEA]'' in clause

    (A)(iv).\678\ In response, the Commissions note that a commodity pool

    that does not qualify for ECP status under clause (A)(iv) of the ECP

    definition may still qualify as an ECP under either of the two clauses

    of the ECP definition other than clause (A)(v) applicable to

    subcategories of commodity pools. Thus, registered investment companies

    and foreign equivalents may qualify as ECPs under clause (A)(iii) of

    the ECP definition, and ERISA plans and the other entities described in

    clause (A)(vi) of the ECP definition may qualify as ECPs thereunder.

    The Commissions' actions in this release do not change that result.

    ---------------------------------------------------------------------------

    \678\ See letter from SIFMA AMG IV.

    ---------------------------------------------------------------------------

    Also, with regard to that commenter's request for clarification,

    for purposes of CFTC Regulation Sec. 1.3(m)(6), the Commissions

    interpret the language ``subject to regulation under the [CEA]'' in

    clause (A)(iv) of the ECP definition as requiring lawful operation of

    the commodity pool by a person excluded from the CPO definition, a

    registered CPO, or a person properly exempt from CPO registration.\679\

    Congress did not limit ECP status under clause (A)(iv) to commodity

    pools operated by persons registered as CPOs; it used the more

    encompassing phrase ``subject to regulation'' under the CEA.\680\ On

    the other hand, to construe that phrase to include any person operating

    a commodity pool would render the phrase superfluous.\681\ The

    commenters' view would enable a CPO that fails to register as required

    to claim that the commodity pool it operates is an ECP under clause

    (A)(v) and thus is not subject to regulation of its retail forex

    transactions. The Commissions believe that construing the phrase

    ``formed and operated by a person subject to regulation under the

    [CEA]'' to refer to a person excluded from the CPO definition,

    registered as a CPO or properly exempt from CPO registration

    appropriately reflects Congressional intent.

    ---------------------------------------------------------------------------

    \679\ For these purposes, the Commissions would take the same

    approach to insignificant deviations from exemptive filings as the

    CFTC does in CFTC Regulation Sec. 4.7(e).

    \680\ If the Commissions interpreted the ``subject to regulation

    under this Act'' language in CEA section 1a(18)(A)(iv)(II) to mean

    that the commodity pool operator must be registered as a CPO and

    limited CPOs to claiming ECP status solely under clause (iv) of the

    ECP definition, then the operators of all commodity pools trading

    swaps would have to register as CPOs to be ECPs. While more CPOs

    will be registering with the CFTC because the CFTC has withdrawn

    CFTC Regulation Sec. 4.13(a)(4), see CPO/CTA Compliance Release,

    and the Dodd-Frank Act has expanded the scope of the transactions

    within the CFTC's jurisdiction, thus reducing the number of CPOs who

    can rely on the 5 percent threshold in CFTC Regulation Sec.

    4.13(a)(3) and thus claim the CPO registration exemption, the CFTC

    did not withdraw 4.13(a)(3), so some CPOs will be able to continue

    to rely on it. Also, not all persons operating commodity pools will

    be CPOs. See CFTC Regulation Sec. 4.5 (exclusion from the

    definition of the term ``commodity pool operator''). The Commissions

    do not believe Congress intended commodity pool ECP status to

    require CPO registration by the commodity pools' operators in all

    cases.

    \681\ If the mere act of forming or operating a commodity pool

    means that a person is ``subject to regulation'' under the CEA, then

    the ``subject to regulation'' language would not be needed.

    ---------------------------------------------------------------------------

    D. Dealers and Major Participants as ECPs

    1. Proposed Approach

    The Commissions proposed to add swap dealers, security-based swap

    dealers, major swap participants and major security-based swap

    participants to the ECP definition on the basis that such persons ``are

    likely to be among the most active and largest users of swaps and

    security-based swaps.'' \682\

    ---------------------------------------------------------------------------

    \682\ Proposing Release, 75 FR at 80184.

    ---------------------------------------------------------------------------

    2. Commenters' Views

    Several commenters supported the proposed addition of swap dealers,

    security-based swap dealers, major swap participants, and major

    security-based swap participants to the ECP definition.\683\ No

    commenter opposed this aspect of the proposal.

    ---------------------------------------------------------------------------

    \683\ One representative commenter stated that ``the proposed

    definition in CFTC Proposed CFTC Regulation Sec. 1.3(m)(1)-(4)

    fills important gaps left by Congress by ensuring that major swap

    participants, major security-based swap participants, swap dealers

    and security-based swap dealers are treated as ECPs.'' See letter

    from Sidley.

    ---------------------------------------------------------------------------

    3. Final Rule

    The Commissions are adopting the new ECP categories as proposed.

    The rules as adopted clarify that the terms ``swap dealer,''

    ``security-based swap dealer,'' ``major swap participant,'' and ``major

    security-based swap participant'' have their respective meanings as

    defined in the CEA and the Exchange Act and as otherwise further

    defined by the Commissions.\684\

    ---------------------------------------------------------------------------

    \684\ These new ECP categories are set forth in new CFTC

    Regulation Sec. 1.3(m)(1)-(4).

    ---------------------------------------------------------------------------

    E. Government Entities: Incorrect Cross-Reference

    1. Description of the Issue

    Clause (A)(vii) of the ECP definition conditions the ECP status of

    governmental entities, and their political subdivisions, agencies,

    instrumentalities and departments (collectively, ``government

    entities''), in part, on the identity of their counterparties.

    Specifically, a government entity may qualify as an ECP under the

    provision in clause (A)(vii) that requires the entity's counterparty to

    be ``listed in any of subclauses (I) through (VI) of section

    2(c)(2)(B)(ii)'' of the CEA.\685\ However, subclauses (I) through (III)

    of CEA section 2(c)(2)(B)(ii) \686\ are unrelated to counterparty types

    (rather, they describe the dollar amounts that apply for purposes of

    retail forex transactions under CEA section 2(c)(2)(B)), and subclauses

    (IV) through (VI) of CEA section 2(c)(2)(B)(ii) no longer exist in the

    statute. Read literally, then, this provision of the ECP definition is

    inherently a nullity and, thus, cannot enable government entities to

    qualify as ECPs.\687\

    ---------------------------------------------------------------------------

    \685\ CEA section 1a(18)(A)(vii)(cc), 7 U.S.C.

    1a(18)(A)(vii)(cc).

    \686\ 7 U.S.C. 2(c)(2)(B)(ii)(I)-(III).

    \687\ A government entity, though, can still qualify as an ECP

    under the other provisions of clause (A)(vii) if it is a certain

    type of ``eligible commercial entity'' as defined in CEA section

    1a(17), 7 U.S.C. 1a(17), or owns and invests on a discretionary

    basis $50 million or more in investments.

    ---------------------------------------------------------------------------

    2. Commenters' Views

    One commenter traced the history of the relevant provisions and

    concluded that the reference to subclauses (I) through (VII) of CEA

    section 2(c)(2)(B)(ii) in clause (A)(vii) of the ECP definition is

    erroneous.\688\ This commenter pointed instead to CEA section

    2(c)(2)(B)(i)(II) \689\ as the reference that should be included in

    clause (A)(vii) of the ECP definition because it lists the entities

    that are eligible to serve as counterparties in retail forex

    transactions.

    ---------------------------------------------------------------------------

    \688\ See letter from Wells Fargo dated June 3, 2011 (``Wells

    Fargo I'').

    \689\ 7 U.S.C. 2(c)(2)(B)(i)(II).

    ---------------------------------------------------------------------------

    This commenter noted that the cross-reference in clause (A)(vii) of

    the ECP definition was correct when it was added to the CEA as part of

    the CFMA, but that it became incorrect in 2008 when an unrelated

    amendment to the CEA was enacted \690\ that changed the numbering of

    the CEA's provisions governing retail forex transactions but that

    failed to make a conforming amendment to clause (A)(vii) of the ECP

    definition. As a result of this 2008 amendment to the CEA, the list of

    entities that formerly appeared in subclauses (I) through (VI) of CEA

    sections 2(c)(2)(B)(ii) now appear in items (aa) through (ff) of CEA

    section

    [[Page 30656]]

    2(c)(2)(B)(i)(II) instead.\691\ This commenter requested that ``the

    Commissions correct this clearly erroneous reference in the definition

    of ECP through interpretive guidance, rulemaking or Commission order.''

    \692\

    ---------------------------------------------------------------------------

    \690\ See section 13101 of the CRA.

    \691\ 7 U.S.C. 2(c)(2)(B)(i)(II)(aa)-(ff).

    \692\ See letter from Wells Fargo I.

    ---------------------------------------------------------------------------

    3. Interpretive Guidance

    Clause (A)(vii) of the ECP definition contains an erroneous cross-

    reference to subclauses (I) through (VI) of CEA section 2(c)(2)(B)(ii).

    Accordingly, the Commissions are issuing interpretive guidance by

    identifying the counterparties with which a governmental entity can

    enter into swaps to attain ECP status under the provision in clause

    (A)(vii) that requires the entity's counterparty to be ``listed in any

    of subclauses (I) through (VI) of section 2(c)(2)(B)(ii)'' of the CEA.

    The Commissions consider a government entity covered by the

    counterparty limitation in clause (A)(vii) to be an ECP with respect to

    an agreement, contract, or transaction that is offered by, and entered

    into with, a person that is listed in items (aa) through (ff) of

    section 2(c)(2)(B)(i)(II) of the CEA. The limitation of ECP status

    ``with respect to'' a particular transaction is consistent with

    Congress' determination that, for purposes of this provision of clause

    (A)(vii), governmental entities may derive their ECP status from the

    status of their counterparty.

    F. Qualification as an ECP With Respect to Swaps Used To Hedge or

    Mitigate Commercial Risk in Connection With the Conduct of an Entity's

    Business

    1. Proposing Release

    In the Proposing Release, the Commissions requested comment on

    whether any additional categories should be added to the definition of

    ECP, ``such as the following categories suggested by commenters [on the

    ANPRM]: Commercial real estate developers; energy or agricultural

    cooperatives or their members; or firms using swaps as hedges pursuant

    to the terms of the CFTC's Swap Policy Statement.'' \693\ As noted

    above, the ECP definition is important because the Dodd-Frank Act

    amended the CEA to prohibit a person that is not an ECP from entering

    into swaps other than on or subject to the rules of a DCM.\694\

    ---------------------------------------------------------------------------

    \693\ See Proposing Release, 75 FR at 80185. The reference to

    the ``Swap Policy Statement'' is to the CFTC's Policy Statement

    Concerning Swap Transactions, 54 FR 30694 (July 21, 1989). The Swap

    Policy Statement ``identifie[d] those swap transactions which [were]

    not * * * regulated as futures or commodity option transactions

    under the [CEA] or the related regulations.'' 54 FR at 30694. One

    element of the Swap Policy Statement required that the swap be

    entered into in connection with each swap counterparty's line of

    business. Id. at 30697. The Swap Policy Statement was applicable to

    cash-settled swaps only, with foreign exchange considered to be cash

    for this purpose. Id. at 30696. The Swap Policy Statement required

    that the terms of the relevant swap be individually tailored,

    meaning that the material terms of the swap had to be negotiated,

    the parties had to make individualized credit determinations, and

    the swap documentation could not be fully standardized. Id. at

    30696-97. The Swap Policy Statement did not apply to swaps subject

    to exchange-style offset, swaps that were cleared or subject to a

    margin system, or swaps marketed to the public. Id. As noted in the

    Product Definitions Proposal, the Dodd-Frank Act supersedes the Swap

    Policy Statement. 76 FR at 29829, n. 74.

    \694\ The discussion in this section relates only to swaps and

    has no effect on the laws or regulations applicable to security-

    based swaps, security-based swap agreements or mixed swaps.

    As noted above, the Dodd-Frank Act also amended the Exchange Act

    and the Securities Act to make it unlawful for a person to effect a

    transaction in a security-based swap with or for a person that is

    not an ECP unless the transaction is effected on a national

    securities exchange registered with the SEC, and to make it unlawful

    for a person to offer to sell, offer to buy or purchase, or sell a

    security-based swap to a person that is not an ECP unless a

    registration statement under the Securities Act is in effect with

    respect to that security-based swap.

    ---------------------------------------------------------------------------

    2. Commenters' Views

    Several commenters supported the addition of categories to the

    definition of ECP because, these commenters said, not all current swap

    market participants are ECPs. Many of these commenters said that non-

    ECPs have entered into swaps in reliance on the Swap Policy

    Statement.\695\ Commenters highlighted, among other things, the

    importance of the Swap Policy Statement to pass-through entities used

    by farmers,\696\ operating companies \697\ and commercial property

    developers,\698\ noting that such entities may not meet the ECP

    criteria. According to these commenters, these pass-through entities

    often are small and medium-sized businesses that enter into interest

    rate swaps with lending financial institutions in reliance on the Swap

    Policy Statement.\699\ The commenters explained that the loans usually

    are guaranteed by the principals of the entity entering into the swap,

    and that the borrower would qualify as an ECP if structured as a

    single-level corporate entity or sole proprietorship.\700\ Commenters

    said that if these non-ECP entities were limited to swaps that are

    available on or subject to the rules of a DCM, many regional bank

    borrowers would lose the ability to use swaps, real estate companies

    would have less flexibility in risk management, and smaller lenders

    would be at a competitive disadvantage.\701\ Another commenter said

    that Dodd-Frank Act provisions such as the end-user clearing exception

    indicate that Congress intended to preserve the availability of swaps

    used for business reasons rather than for investment or

    speculation.\702\

    ---------------------------------------------------------------------------

    \695\ See letter from CDEU. One commenter estimated that swap

    transactions completed by regional and community banks in reliance

    on the Swap Policy Statement constituted 30-40% of all of such

    banks' swaps, representing approximately 7,000 to 10,000 swaps per

    year and $15 to $20 billion in related loan principal. See letter

    from B&F I. Another commenter advised that it has entered 11 swaps,

    with a total notional of $26 million, since its formation in 2007,

    almost all of the counterparties to which ``qualified for the swap

    under the [Swap Policy Statement] business purpose exemption.'' See

    letter from Capstar. The CFTC stated when issuing the Swap Policy

    Statement that it ``reflects the [CFTC]'s view that at this time

    most swap transactions, although possessing elements of futures or

    options contracts, are not appropriately regulated as such under the

    [CEA] and [CFTC] regulations.'' Swap Policy Statement at 30694.

    \696\ See, e.g., letter from Rabobank, N.A., Rabo AgriFinance,

    Inc. and Co[ouml]peratieve Centrale Raiffeisen-Boerenleenbank B.A.

    (``Rabobank, New York Branch'') (relating that ``[f]or a variety of

    estate planning and regulatory purposes, farmers commonly hold their

    ownership interests in land, buildings and farm equipment

    indirectly, through a network of legal entities'').

    \697\ See, e.g., letter from Fifth Third Bank and Union Bank,

    N.A. (advising that ``[i]t is common for an operating business to

    organize a separate limited liability company (for tax and legal

    reasons) to acquire * * * assets * * * and to lease these assets to

    the operating company[, which] becomes the borrow[er] * * * for the

    loan used to acquire those assets'' and that ``[t]he limited

    liability company often does not maintain sufficient capital to

    qualify as an ECP'').

    \698\ See, e.g., letters from Capstar, Frost National Bank, FTN

    Financial Capital Markets, Midsize Banks and NAREIT.

    \699\ See letters from BB&T I and B&F I. Commenters said that

    these businesses may intentionally maintain less than $1 million in

    equity primarily for tax and legal reasons. See letters from Capital

    One and Columbia State Bank (stating that over 65% of its borrowers

    are structured as limited liability companies or S corporations and

    intentionally maintain less than $1 million in equity at the entity

    entering into the swap).

    \700\ See letter from Columbia State Bank. See also letter from

    BB&T I.

    \701\ See letters from BB&T I, Capital One, Capstar, Columbia

    State Bank, Midsize Banks, NAREIT and Wells Fargo II.

    \702\ See letter from FSR I.

    ---------------------------------------------------------------------------

    To mitigate the impact of restricting non-ECPs to swaps that are

    available on or subject to the rules of DCMs, some commenters said that

    an entity should be able to qualify as an ECP based on the financial

    qualifications of related entities, so long as various conditions

    proposed by the commenters are satisfied. Some commenters said that an

    entity should be eligible to be an ECP if its swap obligations are

    guaranteed by an ECP,\703\ or if its controlling entity qualifies as an

    ECP under clause (A)(v) of the statutory definition.\704\ Another

    commenter suggested revisions to the

    [[Page 30657]]

    ECP definition that included looking to the ECP status or

    sophistication of the majority owner of an entity in determining if the

    entity itself is an ECP.\705\ Other commenters suggested other

    provisions to allow non-ECPs to enter into swaps other than on or

    subject to the rules of a DCM, so long as the non-ECP meets various

    conditions indicating that the swap is used in connection with its line

    of business.\706\

    ---------------------------------------------------------------------------

    \703\ See letters from BB&T I, Midsize Banks and Wells Fargo II.

    \704\ See letters from CDEU and Regional Banks.

    \705\ See letter from NAREIT.

    \706\ See letters from the American Public Gas Association

    (``APGA''), Capital One and Gavilon dated December 23, 2010

    (``Gavilon I'').

    ---------------------------------------------------------------------------

    Other commenters argued for per se ECP qualification based on their

    status as certain types of persons, such as farmers\707\ or for ECP

    status based solely on a combination of a person's status and the swap

    being related to a person's line of business with no additional

    conditions.\708\

    ---------------------------------------------------------------------------

    \707\ See meeting with Ron Eliason on December 16, 2010 (in

    which Mr. Eliason contended that farmers should be able to enter

    into swaps, even if they do not meet the income or asset tests in

    the current ECP definition and, therefore, would not be permitted to

    enter into swaps other than on or subject to the rules of a DCM).

    \708\ See letter from APGA (requesting that ``the [CFTC]

    exercise its authority under section la(18)(C) of the Act and

    determine that public natural gas distribution companies, including

    member-owned co-operatives, that enter into swaps in connection with

    their business of supplying customers with natural gas are ECPs

    within the meaning of section la(18) of the Act'').

    ---------------------------------------------------------------------------

    3. Final Rules and Interpretation

    In response to the commenters' concerns, the CFTC is adopting CFTC

    Regulation Sec. 1.3(m)(7) to permit an entity, in determining its net

    worth for purposes of subclause (A)(v)(III) of the ECP definition,\709\

    to include the net worth of its owners, solely for purposes of

    determining its ECP status for swaps used to hedge or mitigate

    commercial risk, provided that all of its owners are themselves ECPs

    (disregarding shell companies). Under CFTC Regulation Sec. 1.3(m)(7)

    as adopted, an entity seeking to qualify under subclause (A)(v)(III) of

    the ECP definition in order to enter into a swap used to hedge or

    mitigate commercial risk is permitted to count the net worth of its

    owners in determining its own net worth, so long as all its owners are

    ECPs. This regulation applies only to entities that are otherwise

    eligible to rely on subclause (A)(v)(III) to determine ECP status; it

    does not expand or change the scope of application of that

    paragraph.\710\

    ---------------------------------------------------------------------------

    \709\ CEA section 1a(18)(A)(v)(III) provides that the term

    ``eligible contract participant'' includes ``a corporation,

    partnership, proprietorship, organization, trust, or other entity *

    * * that (aa) has a net worth exceeding $1,000,000; and (bb) enters

    into an agreement, contract, or transaction in connection with the

    conduct of the entity's business or to manage the risk associated

    with an asset or liability owned or incurred or reasonably likely to

    be owned or incurred by the entity in the conduct of the entity's

    business.'' 7 U.S.C. 1a(18)(A)(v)(III).

    \710\ For example, if a commodity pool were precluded by CFTC

    Regulation Sec. 1.3(m)(6) from relying on clause (A)(v) of the

    statutory definition to qualify as an ECP, such pool would not be

    able to rely on CFTC Regulation Sec. 1.3(m)(7) to qualify as an

    ECP.

    ---------------------------------------------------------------------------

    CFTC Regulation Sec. 1.3(m)(7) as adopted applies only when

    determining ECP status for swaps used to hedge or mitigate commercial

    risk. This new regulation does not apply when determining ECP status

    for other swaps or for security-based swaps, security-based swap

    agreements, mixed swaps, or agreements, contracts or transactions that

    are not swaps (regardless of the purpose for which they are used).

    The Commissions have considered the comments indicating that, as

    currently structured, many businesses are owned by multiple legal

    entities and/or individuals, and the net worth of all the owners in the

    aggregate in some cases would satisfy the $1 million net worth

    requirement in subclause (A)(v)(III), even though the particular legal

    entity that enters into a swap does not have a net worth exceeding $1

    million.\711\ While the Commissions recognize that the requirement, in

    subclause (A)(v)(III)(aa) of the ECP definition, that the entity

    relying on that paragraph have a net worth exceeding $1 million

    evidences Congress' intent that only entities with this level of

    financial resources should be eligible for ECP status under this

    paragraph of the definition, the Commissions agree with commenters that

    application of this requirement in these circumstances would

    inappropriately limit the ability of business entities to use swaps to

    hedge or mitigate commercial risk. As a result, the Commissions are

    persuaded that in this limited situation, the entity should qualify as

    an ECP and be eligible to enter into swaps other than on or subject to

    the rules of a DCM, so long as the entity is using the swap to hedge or

    mitigate commercial risk and all of the owners of the entity are ECPs

    (other than shell companies).

    ---------------------------------------------------------------------------

    \711\ See, e.g., letters from B&F I (stating that ``[i]f the

    customer does not * * * [itself] meet the ECP definition, then the

    transaction would have to be guaranteed by any entity or individual

    who is an owner * * * [who] meets the $10,000,000 total asset test

    of section 1(a)(18)(A)(v)(I) of the Act or the $1,000,000 net worth

    test of section 1(a)(18)(A)(v)(III) of the Act.''), NAREIT (urging

    that the Commissions impute ECP status to non-ECP entities involved

    in specified real estate businesses to such entities whose

    ``majority owner or controlling entity'' is an ECP) and Midsize

    Banks (recommending that the ECP determination be made with respect

    to a non-ECP entity's owners based on criteria including qualifying

    natural persons as ECPs based on a $1,000,000 net worth).

    ---------------------------------------------------------------------------

    In response to those commenters requesting per se ECP status or the

    ability to qualify as an ECP based on a combination of status and

    engaging in swaps related to a line of business, without further

    restriction, the Commissions do not believe it is necessary or

    appropriate to further define the term ECP to such an extent in order

    to address most commenters' concerns. The Commissions note that such

    approaches would undermine the prohibition in CEA section 2(e) \712\ on

    non-ECPs executing swaps other than on or subject to the rules of a

    DCM. The Commissions also note that focusing solely on a link between a

    swap and a line of business would undermine the application of the ECP

    definition to swaps in that the various prongs of the ECP generally are

    linked to dollar thresholds, regulated status, or a combination of the

    two.

    ---------------------------------------------------------------------------

    \712\ 7 U.S.C. 2(e).

    ---------------------------------------------------------------------------

    The Commissions also note that it currently is considering a draft

    petition for relief pursuant to CEA section 4(c)(6)(C) \713\ for

    certain entities described in Federal Power Act section 201(f),\714\

    which may address the concerns of some commenters. Additionally, the

    Commissions are developing joint rules to further define the term

    ``swap,'' including the forward exclusion from the swap definition

    which, in turn, may result in certain transactions not being considered

    swaps. Further, the CFTC also is considering today a form of trade

    option exemption, which may further address commenters' concerns.

    ---------------------------------------------------------------------------

    \713\ 7 U.S.C. 6(c)(6)(C).

    \714\ 16 U.S.C. 824(f).

    ---------------------------------------------------------------------------

    With respect to farmers, in response to the CFTC's Commodity

    Options and Agricultural Swaps rulemaking proposal,\715\ commenters

    generally were of the view that the ECP definition is appropriate in

    its current form.\716\ While

    [[Page 30658]]

    the Commissions may consider providing further relief should experience

    show, after the ECP definition becomes effective, that further relief

    is warranted, neither the ECP definition nor the various actions cited

    in the foregoing paragraph are final, so providing further relief is

    premature. The Commissions' measured approach, which builds on the

    existing net worth requirement in the general entity ECP category,

    provides broad relief to many of the commenters (e.g., borrowers

    generally) while otherwise adhering to the existing ECP categories.

    ---------------------------------------------------------------------------

    \715\ 76 FR 6095 (Feb. 3, 2011).

    \716\ See, e.g., letters from NCFC dated April 4, 2011 (``NCFC

    II'') (stating ``[o]n behalf of the more than two million farmers

    and ranchers who belong to one or more farmer cooperative(s), the

    [NCFC] * * * [believes] the limitation on participation [in

    agricultural swaps] to [ECPs] outside of a DCM * * * should limit

    [agricultural swap] participation to appropriate persons'' and that

    ``[t]he ECP requirement with a threshold of $1 million in net worth

    to be allowed to use swaps and options, other than on a DCM, is

    appropriate for the products cooperatives offer their members''), ;

    letter from NGFA dated April 4, 2011 (``NGFA II'') (stating that

    ``[t]he use of agricultural swaps has been constrained relative to

    other swaps by virtue of being subject to CFTC regulatory

    requirements, while other swaps have been exempted from CFTC

    oversight,'' ``the Dodd-Frank Act * * * institutes a number of

    safeguards, including the limitation that only [ECPs] may engage in

    swaps unless entered into on a designated contract market,'' and

    ``[t]he NGFA believes that these safeguards provide more-than-ample

    protection in the swaps marketplace for both agricultural and non-

    agricultural swaps and that there is no compelling reason to place

    additional burdens on agricultural swaps.'').

    ---------------------------------------------------------------------------

    The Commissions note that commenters said that, because of the way

    some businesses are structured for tax, estate planning or other

    purposes, they enter into swaps through a legal entity that does not,

    by itself, qualify as an ECP even though the net worth of the business

    and its owners, taken in the aggregate, would qualify as an ECP

    pursuant to subclause (A)(v)(III) of the ECP definition. The

    Commissions believe that the best way to address this concern is to

    allow such a business to consider the net worth of all its owners in

    determining whether the net worth requirement in subclause (A)(v)(III)

    is satisfied.\717\

    ---------------------------------------------------------------------------

    \717\ The Commissions note that this regulation provides an

    alternative means for certain business entities to qualify as ECPs.

    It neither diminishes nor qualifies in any way the requirement in

    CEA section 2(e) that persons that are not ECPs enter into swaps

    only on or subject to the rules of a DCM.

    ---------------------------------------------------------------------------

    CFTC Regulation Sec. 1.3(m)(7) is available only to an entity that

    seeks to qualify as an ECP under subclause (A)(v)(III) of the statutory

    definition in order to enter into a swap that will be used to hedge or

    mitigate commercial risk. The Commissions limited CFTC Regulation Sec.

    1.3(m)(7) to subclause (A)(v)(III) because this provision of the ECP

    definition is available to a business entity that uses swaps in

    connection with the conduct of its business or to manage risks

    associated with assets or liabilities related to the conduct of its

    business.\718\

    ---------------------------------------------------------------------------

    \718\ CEA section 1a(18)(A)(v)(III)(bb), 7 U.S.C.

    1a(18)(A)(v)(III)(bb). The Commissions note that an entity that

    would qualify as an ECP under subclause (A)(v)(III) without

    application of CFTC Regulation Sec. 1.3(m)(7) is not required to

    meet the conditions stated in, this regulation.

    ---------------------------------------------------------------------------

    The purpose of CFTC Regulation Sec. 1.3(m)(7) is to maintain the

    ability of business entities to enter into swaps other than on or

    subject to the rules of a DCM for limited purposes. This regulation

    therefore is available only with respect to a swap that is used to

    hedge or mitigate commercial risk within the meaning of CFTC Regulation

    Sec. 1.3(kkk).\719\ CFTC Regulation Sec. 1.3(m)(7) applies only if

    all of an entity's owners qualify as ECPs under the provision of the

    ECP definition applicable to such owner. Although some commenters

    suggested that an entity should be able to qualify as an ECP based on

    the status of its majority or controlling owners,\720\ the Commissions

    believe that CFTC Regulation Sec. 1.3(m)(7) should be available only

    when all of an entity's owners qualify as ECPs. The Commissions do not

    believe it would be appropriate to impair the protection of non-ECPs

    that flows from the requirement that non-ECPs enter into swaps only on

    or subject to the rules of a DCM.\721\ In order to maintain these

    protections and prevent evasion, CFTC Regulation Sec. 1.3(m)(7)

    provides that any shell company will be disregarded, and in order to

    determine if the underlying entity may use CFTC Regulation Sec.

    1.3(m)(7), each owner of such shell company must be an ECP.\722\

    ---------------------------------------------------------------------------

    \719\ See part IV.C. The use of the phrase ``hedge or mitigate

    commercial risk'' in CFTC Regulations Sec. Sec. 1.3(m)(7) and

    1.3(kkk) is similar to the use of the same phrase in the exception

    to the mandatory clearing requirement in CEA section 2(h)(7), 7

    U.S.C. 2(h)(7).

    \720\ See, e.g., letter from NAREIT.

    \721\ See CEA section 2(e), 7 U.S.C. 2(e).

    \722\ See CFTC Regulation Sec. 1.3(m)(7)(ii).

    The term ``shell company'' means any entity that limits its

    holdings to direct or indirect interests in entities that are ECPs

    through reliance on CFTC Regulation Sec. 1.3(m)(7). Any entity that

    holds at least one direct or indirect interest in an entity not

    relying on CFTC Regulation Sec. 1.3(m)(7) would not be a shell

    company. The ECP status of owners of entities that are not shell

    companies is not relevant for purposes of CFTC Regulation Sec.

    1.3(m)(7), which should permit wider financing of small businesses

    using swaps to hedge or mitigate commercial risk.

    To be clear, an individual will never be considered to be a

    shell company for purposes of CFTC Regulation Sec. 1.3(m)(7).

    ---------------------------------------------------------------------------

    Correspondingly, in aggregating net worth for purposes of

    determining the ECP status of an entity pursuant to CFTC Regulation

    Sec. 1.3(m)(7), if the entity is owned by a shell company, then it is

    the net worth of the owners of that shell company that is relevant, not

    the net worth of the shell company.\723\

    ---------------------------------------------------------------------------

    \723\ This provision may apply repeatedly in a ``chain.'' For

    example, if in determining whether an entity may rely on CFTC

    Regulation Sec. 1.3(m)(7), an owner of that entity that is a shell

    company is disregarded, then if the owner of that shell company is

    also a shell company, that second shell company also is disregarded,

    and so on.

    ---------------------------------------------------------------------------

    Last, also in order to prevent evasion, CFTC Regulation Sec.

    1.3(m)(7)(ii)(C) specifies that an individual may rely on the

    proprietorship provision of clause (A)(v) of the statutory definition

    for purposes of determining its status as an ECP owner of an entity

    only if the proprietorship \724\ status arises independent of the

    business conducted by such entity \725\ and the individual proprietor

    acquires his/her interest in such entity (i) in connection with the

    conduct of the individual's proprietorship or (ii) to manage the risk

    associated with an asset or liability owned or incurred or reasonably

    likely to be owned or incurred by the proprietorship.\726\ The

    Commissions are adopting CFTC Regulation Sec. 1.3(m)(7)(ii)(C) because

    they believe that the only circumstance in which a proprietorship

    should be considered an ECP for purposes of CFTC Regulation Sec.

    1.3(m)(7)(i) is if it is making an investment related to the

    proprietorship.\727\ The ECP status of an individual acting other than

    with respect to its proprietorship is determined based on the ECP

    clause applicable to individuals. The Commissions note that they have

    authority to take action to prevent evasion of the provisions regarding

    shell companies and proprietorships by entities relying on CFTC

    Regulation Sec. 1.3(m)(7) to establish ECP status.

    ---------------------------------------------------------------------------

    \724\ A proprietorship generally is a business that a person

    operates in a personal capacity and with respect to which that

    person directly owns all the assets and directly is responsible for

    all of the liabilities, rather than through a corporation,

    partnership or other structure conveying limited liability. See

    letters from Midmarket Banks and Wells Fargo II (stating that

    ``proprietors . . . typically are not separate legal entities'');

    see also State of California Franchise Tax Board Web site (advising

    that ``[t]he business and the owner are one. There is no separate

    legal entity and thus no separate legal person''), at https://www.ftb.ca.gov/businesses/bus_structures/soleprop.shtml. A

    proprietorship is not a separate taxable entity but reports the

    income or loss of the business, which is taxed along with a sole

    proprietor's other income, on a separate schedule attached to his or

    her individual federal income tax return. See letter from Midmarket

    Banks. See also 2011 Form1040 Schedule C: Profit or Loss from

    Business (Sole Proprietorship), available at http://www.irs.gov/pub/irs-pdf/f1040sc.pdf; 2011 Instructions for Schedule C, available at

    http://www.irs.gov/pub/irs-pdf/i1040sc.pdf.

    \725\ CFTC Regulation Sec. 1.3(m)(7)(ii)(C)(I) is designed to

    ensure that the individual qualifies as a proprietorship, if at all,

    other than due to its interest in either an entity seeking to

    qualify as an ECP under CFTC Regulation Sec. 1.3(m)(7)(i) or in any

    other entity.

    \726\ See CFTC Regulation Sec. 1.3(m)(7)(ii)(C)(IV). This

    language is modeled on the language in 7 U.S.C.

    1a(18)(A)(v)(III)(bb).

    \727\ The Commissions note that this guidance regarding

    proprietorships applies only when an entity is relying on CFTC

    Regulation Sec. 1.3(m)(7). The Commissions do not intend that this

    guidance would expand or limit the circumstances when a

    proprietorship may otherwise rely on clause (A)(v) of the statutory

    definition in establishing its ECP status.

    ---------------------------------------------------------------------------

    [[Page 30659]]

    G. ECP Status for Forex Pools Operated by Registered CPOs or CPOs

    Exempt From Registration Under Certain Conditions

    1. Description of the Issue and Commenters' Views

    Notwithstanding the modifications to the look-through provisions

    for Forex Pools discussed above in section III.B., the Commissions

    acknowledge commenters' concerns about the potential for unintended

    consequences arising from the look-through provisions of the Dodd-Frank

    Act. Several commenters asserted that many Forex Pools are operated by

    sophisticated, professional managers that do not need the protections

    of a retail forex regime designed to protect non-ECPs that are engaging

    in retail forex transactions.\728\ More specifically, some commenters,

    based on CFTC enforcement actions involving Forex Pools, suggested that

    commodity pools of a sufficient size, and/or operated by a registered

    or exempt CPO, do not pose the risks of fraud and abuse of non-ECP

    customers that the statutory look-through provision is intended to

    address.\729\

    ---------------------------------------------------------------------------

    \728\ See, e.g., letters from Millburn (characterizing the

    proposed rules as ``greatly limit[ing] the ability of entities

    managed by sophisticated money managers that are subject to

    registration and examination by regulators to qualify as ECPs'') and

    Sidley (describing ``[a] commodity pool, like a registered

    investment company or an employee benefit plan, [a]s a pool of

    assets from investors of varying (and, in some cases, undetermined)

    levels of sophistication that are advised by a sophisticated

    adviser'').

    \729\ See joint letter from the Global Foreign Exchange Division

    (``GXFD'') and MFA dated January 19, 2011 (``GFXD II'') (describing

    35 CFTC Forex Pool enforcement cases from 2010 and 2011 and noting

    that in 80% of these cases, the amount at issue in the misconduct

    was less than $10 million, and that only one case involved a

    registered CPO where the amount at issue in the misconduct was more

    than $10 million; two additional cases involved misconduct involving

    CPOs exempt from registration as such under CFTC Regulation Sec.

    4.13(a). While the commenter did not characterize these amounts as

    ``total assets'' (instead, the commenter used terms such as

    ``fraudulently obtained'' or ``sustained losses of'' to modify the

    cited dollar amounts) in most cases, it is clear that these amounts

    are equivalent to, or subsets of, total assets. For instance, for a

    CPO to have fraudulently obtained $10 million from commodity pool

    participants, the CPO must have taken in $10 million from them,

    resulting in the commodity pool at one time having $10 million in

    total assets. See also letter from Sidley (providing 26 examples of

    CFTC Forex Pool-related enforcement cases, all but one of which

    involved Forex Pools with less than $50 million in total assets). A

    number of the cases cited by GXFD and Sidley overlap; in the

    aggregate, these commenters appear to have presented data on 45

    different cases rather than 61.

    ---------------------------------------------------------------------------

    As a result, commenters suggested that the look-through provision

    should not apply in determining ECP status of commodity pools that meet

    certain conditions. For example, commenters suggested that the look-

    through not be applied to a commodity pool with $10 million in total

    assets paired with another or other factors, such as not being

    structured to evade,\730\ being subject to regulation under the

    CEA\731\ or the CPO being registered as such.\732\ Another commenter

    suggested requiring the total assets or minimum initial investment of a

    Forex Pool to be sufficiently large that, in general, only legitimate

    pools would exceed such thresholds.\733\ This commenter suggested a

    total asset threshold of $50 million.\734\

    ---------------------------------------------------------------------------

    \730\ See letter from GFXD II.

    \731\ See letters from GXFD II and Skadden.

    \732\ See meeting with SIFMA on January 20, 2012 (in which

    representatives of SIFMA proposed a new non-exclusive set of

    criteria for a Forex Pool to qualify as an ECP, which included, as

    one of several alternatives in one element of the proposed criteria,

    that a Forex Pool be operated by a registered CPO). See also letter

    from Willkie Farr (observing that ``[i]t may be time to regulate

    certain previously unregulated transactions and traders, so that

    more CPOs are registered'' and that ``many commodity pools are

    operated and advised by registered professionals'').

    \733\ See letter from Sidley.

    \734\ See id.

    ---------------------------------------------------------------------------

    Separately, one commenter also claimed that the statutory look-

    through, if strictly implemented, might inappropriately preclude Forex

    Pools and their CPOs, many of whom are registered, from engaging in

    retail forex transactions with swap dealers because swap dealers are

    not Enumerated Counterparties (and some swap dealers also may not be

    Enumerated Counterparties in a different capacity, such as being a U.S.

    financial institution).\735\ This commenter stated that such a result

    could reduce close out netting opportunities in the event of the

    insolvency of a counterparty.

    ---------------------------------------------------------------------------

    \735\ See joint letter from the GFXD and MFA dated January 10,

    2012 (``GFXD I''). These commenters indicated that, while

    [s]ome swap dealers may be dually licensed as a bank or a

    broker-dealer [and therefore] eligible to transact in OTC foreign

    exchange with retail investors as well as swaps with institutional

    investors * * * as an operational matter, it is not clear that firms

    will be able to and find it efficient to structure their business so

    that the retail foreign exchange platform is conducted from the same

    entity as the institutional swaps business.

    ---------------------------------------------------------------------------

    2. Final Rule

    In response to commenters, the CFTC is adopting CFTC Regulation

    Sec. 1.3(m)(8), pursuant to which certain Forex Pools may qualify as

    ECPs notwithstanding the look-through requirement. As adopted, CFTC

    Regulation Sec. 1.3(m)(8) enables a Forex Pool that enters into a

    retail forex transaction to qualify as an ECP with respect thereto,

    irrespective of whether each participant in the Forex Pool is an ECP,

    if the Forex Pool satisfies the following conditions:

    It is not formed for the purpose of evading CFTC

    regulation under Section 2(c)(2)(B) or Section 2(c)(2)(C) of the CEA or

    related CFTC rules, regulations or orders governing Retail Forex Pools

    and retail forex transactions);

    It has total assets exceeding $10 million; and

    It is formed and operated by a registered CPO or by a CPO

    who is exempt from registration as such pursuant to CFTC Regulation

    Sec. 4.13(a)(3).

    CFTC Regulation Sec. 1.3(m)(8) as adopted requires that the Forex

    Pool not be formed for the purpose of evading CFTC regulation of Retail

    Forex Pools and retail forex transactions under CEA Section 2(c)(2)(B)

    or (C). A Forex Pool that is formed for that purpose would not be an

    ECP under new CFTC Regulation Sec. 1.3(m)(8).

    CFTC Regulation Sec. 1.3(m)(8) as adopted also requires that the

    Forex Pool have total assets exceeding $10 million to qualify as an

    ECP. The $10 million threshold is twice the current total asset

    threshold for a commodity pool to qualify as an ECP under CEA section

    1a(18)(A)(iv). The Commissions believe the $10,000,000 threshold is

    appropriate in light of the potential regulatory burdens a higher

    threshold might impose on smaller commodity pools. The Commissions

    believe that such a threshold, coupled with the other conditions of the

    rule, is sufficiently high to assure that the protections provided to

    retail forex transactions are not needed for these types of commodity

    pools. The Commissions will vigilantly monitor developments with

    respect to Forex Pools, including enforcement activity, and revisit

    this total asset threshold if warranted by subsequent events.

    Finally, CFTC Regulation Sec. 1.3(m)(8) as adopted requires that

    Forex Pool be formed \736\ and operated by a CPO registered as such

    with the CFTC or by a CPO who is exempt from registration as such

    pursuant to CFTC Regulation Sec. 4.13(a)(3). The Commissions believe

    that the registered CPO aspect of this condition is appropriate for

    several reasons, including that it will ensure

    [[Page 30660]]

    that the NFA oversees compliance by those registered CPOs relying on

    this new regulation.\737\ CPO registration also provides a clear means

    of addressing wrongful conduct.\738\ Although some commenters suggested

    that a CPO need only be ``subject to regulation under the CEA'' in

    order for a Forex Pool operated by that CPO to qualify as an ECP

    notwithstanding the look-through requirements, CFTC Regulation Sec.

    1.3(m)(8) instead requires that the CPO of a Forex Pool be registered

    as a CPO or be a CPO who is exempt from registration as such pursuant

    to CFTC Regulation Sec. 4.13(a)(3), alternative conditions supported

    by other commenters. The Commissions are requiring operation by a

    registered CPO, or by a CPO who is exempt from registration as such

    pursuant to CFTC Regulation Sec. 4.13(a)(3), as a condition for a

    Forex Pool to qualify for ECP status under CFTC Regulation Sec.

    1.3(m)(8) because, based on the data presented by commenters, CFTC

    enforcement actions involving Forex Pools rarely involve registered

    CPOs or CPOs exempt from registration as such.\739\

    ---------------------------------------------------------------------------

    \736\ Given that (i) many CPOs will be registering as such for

    the first time due to the CFTC's recent rescission of the exemption

    from CPO registration set forth in CFTC Regulation Sec. 4.13(a)(4)

    or its modification of the criteria for claiming the exclusion from

    the CPO definition in CFTC Regulation Sec. 4.5 and (ii) such pools

    were formed prior to their CPOs' registration as such, commodity

    pools formed prior to December 31, 2012 need not have been

    ``formed'' by a registered CPO or by a CPO exempt from registration

    as such pursuant to CFTC Regulation Sec. 4.13(a)(3) in order to be

    qualified as ECPs under the new prong, so long as they are operated

    by a registered CPO on or before such date.

    \737\ See CPO/CTA Compliance Release at 11254 (noting that

    ``registration allows the Commission to ensure that all entities

    operating collective investment vehicles participating in the

    derivatives markets meet minimum standards of fitness and

    competency''). See http://www.nfa.futures.org/NFA-registration/cpo/index.html for an overview of registration and related requirements

    for CPOs, their principals and their associated persons and http://www.nfa.futures.org/NFA-compliance/NFA-commodity-pool-operators/index.html for an overview of the compliance regime for registered

    CPOs overseen by the NFA. The CFTC anticipates that more CPOs will

    register in the coming months now that it has withdrawn the CFTC

    Regulation Sec. 4.13(a)(4) exemption from CPO registration,

    increasing the number of registered CPOs, in turn increasing the

    number of CPOs who can satisfy the registered CPO alternative under

    CFTC Regulation Sec. 1.3(m)(8)(iii).

    \738\ See CPO/CTA Compliance Release at 11254 (stating that

    ``the [CFTC] has clear authority to take punitive and/or remedial

    action against registered entities for violations of the CEA or of

    the [CFTC''s regulations * * * [and] to deny or revoke registration,

    thereby expelling an individual or entity from serving as an

    intermediary in the industry'' and that the CFTC's reparations

    program and the NFA's arbitration program also are available avenues

    ``to seek redress for wrongful conduct by a [CFTC] registrant'').

    \739\ As discussed above in note 729, only one of the 45 unique

    cases presented by commenters involved a pool with more than $10

    million in total assets and a registered CPO. Only two of those

    cases involved a pool operated by CPOs exempt from registration: in

    both of those cases, however, the CPO raised less than $10 million.

    In addition, one of those CPOs relied on the CFTC Regulation Sec.

    4.13(a)(4) CPO registration exemption. As discussed above, the CFTC

    has withdrawn that exemption.

    ---------------------------------------------------------------------------

    While NFA oversight of CPOs operating Retail Forex Pools is a

    useful criterion to determine whether an exclusion from the look-

    through provisions of CEA section 1a(8)(A)(iv) and CFTC Regulation

    Sec. 1.3(m)(5) is warranted, the Commissions believe that Retail Forex

    Pools operated by CPOs exempt from registration as such pursuant to

    CFTC Regulation Sec. 4.13(a)(3) also merit relief from those look-

    through provisions. On September 10, 2010, the CFTC published in the

    Federal Register a final rule revising the CPO registration exemption

    in CFTC Regulation Sec. 4.13(a)(3) to incorporate retail forex

    transactions into the transactions subject to the alternative caps on

    the use of commodity interests \740\ by CPOs claiming the

    exemption.\741\ The CFTC explained in the related Federal Register

    proposing release that the proposed change to CFTC Regulation Sec.

    4.13(a)(3) was part of a proposal to adopt a comprehensive regulatory

    scheme to implement the CRA with respect to retail forex transactions

    (``CRA-Related Forex Proposal'').\742\ The CFTC also explained that

    ``the NFA-specified minimum security deposit for off-exchange retail

    forex transactions would be included among the amounts that cannot

    exceed 5 percent of the liquidation value of the pool's portfolio in

    order for the operator to claim the exemption from registration under

    Regulation 4.13(a)(3)''\743\ and that ``such amounts are roughly

    equivalent to initial margin and option premiums).'' \744\ The CFTC

    also described the CRA-Related Forex Proposal as ``amend[ing] existing

    regulations as needed to clarify their application to, and inclusion

    in, the new regulatory scheme for retail forex.'' \745\ More recently,

    notwithstanding the Dodd-Frank Act's addition of the look-through

    provision in CEA section 1a(8)(A)(iv), the CFTC determined to retain

    the exemption from CPO registration under Regulation 4.13(a)(3),

    reasoning that ``overseeing entities with less than five percent

    exposure to commodity interests is not the best use of the Commission's

    resources.'' \746\

    ---------------------------------------------------------------------------

    \740\ The term ``commodity interest'' is defined in CFTC

    Regulation Sec. 1.3(yy), and includes ``[a]ny contract, agreement

    or transaction subject to [CFTC] jurisdiction under section 2(c)(2)

    of the [CEA].'' CFTC Regulation Sec. 1.3(yy)(3).

    \741\ See CFTC, Regulation of Off-Exchange Retail Foreign

    Exchange Transactions and Intermediaries; Final Rules, 75 FR 55410

    (Sept. 10, 2010).

    \742\ CFTC, Regulation of Off-Exchange Retail Foreign Exchange

    Transactions and Intermediaries; Proposed Rules, 75 FR 3282 (Jan.

    10, 2010).

    \743\ Section 12 of the NFA's Financial Requirements impose the

    following minimum security deposit requirements for retail forex

    transactions: (i) 2% of the notional value of transactions in the

    British pound, the Swiss franc, the Canadian dollar, the Japanese

    yen, the Euro, the Australian dollar, the New Zealand dollar, the

    Swedish krona, the Norwegian krone, and the Danish krone; (ii) 5% of

    the notional value of other transactions; (iii) for short options,

    the above amount plus the premium received; and (iv) for long

    options, the entire premium. See NFA Manual, available at http://www.nfa.futures.org/nfamanual/NFAManual.aspx?RuleID=SECTION%2012&Section=7.

    \744\ CFTC, Regulation of Off-Exchange Retail Foreign Exchange

    Transactions and Intermediaries; Proposed Rules, 75 FR 3282, 3287

    (Jan. 10, 2010).

    \745\ Id. at 3282.

    \746\ CPO/CTA Compliance Release at 11261. The CFTC also stated

    that:

    [t]he Commission believes that trading exceeding five percent of

    the liquidation value of a portfolio, or a net notional value of

    commodity interest positions exceeding 100 percent of the

    liquidation value of a portfolio, evidences a significant exposure

    to the derivatives markets, and that such exposure should subject an

    entity to the Commission's oversight.

    Id. at 11263.

    ---------------------------------------------------------------------------

    Given that, shortly before the adoption of the Dodd-Frank Act, the

    CFTC proposed to add retail forex transactions to those that can be

    entered into by CPOs claiming relief from registration as such under

    CFTC Regulation Sec. 4.13(a)(3), that it finalized that action shortly

    after the Dodd-Frank Act was adopted and that it recently left CFTC

    Regulation Sec. 4.13(a)(3) in place despite having proposed to

    withdraw that CPO registration exemption, and for the reasons described

    above, the Commissions believe CPOs exempt from registration as such

    pursuant to CFTC Regulation 4.13(a)(3) and operating Retail Forex Pools

    should be able to continue to do so outside the retail forex regime.

    Section 712(d)(2)(A) of the Dodd-Frank Act grants the Commissions

    the authority to adopt such rules related to the ECP definition as the

    Commissions determine are necessary and appropriate, in the public

    interest, and for the protection of investors. Based on commenters'

    views, the Commissions have determined that CFTC Regulation Sec.

    1.3(m)(8) as adopted is necessary and appropriate because the statutory

    look-through provision, if strictly implemented, would subject Forex

    Pools operated by CPOs that are sophisticated, professional asset

    managers to an array of additional compliance costs and deprive them of

    access to swap dealers as counterparties when engaging in retail forex

    transactions.\747\ The Commissions also have determined that it is

    appropriate to limit the availability of ECP status under CFTC

    Regulation Sec. 1.3(m)(8) to Forex

    [[Page 30661]]

    Pools operated by registered CPOs or by CPOs exempt from registration

    as such pursuant to CFTC Regulation Sec. 4.13(a)(3).\748\ The

    conditions in CFTC Regulation Sec. 1.3(m)(8) also are appropriate in

    that they require Forex Pools seeking ECP status thereunder to have

    total assets exceeding $10 million. Historically, CFTC enforcement

    actions have involved fewer instances of misconduct by CPOs of Forex

    Pools with total assets above this threshold.\749\

    ---------------------------------------------------------------------------

    \747\ The nature of a swap dealer's business activities and

    assets may detract from what is considered regulatory capital for an

    FCM or RFED engaging in retail forex transactions, thereby making it

    difficult for some swap dealers to dually register both as such and

    as an FCM or RFED in order to do retail forex business. As an ECP, a

    Forex Pool's choice of retail forex transaction counterparties will

    not be limited to Enumerated Counterparties, and thus may include

    swap dealers.

    \748\ The Commissions note that the statistics presented by

    commenters indicate that Forex Pool misconduct by registered CPOs

    and those exempt from CPO registration is significantly rarer than

    Forex Pool misconduct by otherwise unregistered CPOs. See letter

    from the GFXD II.

    \749\ See letter from Sidley (showing that 6 of the 27 cases

    presented involved more than $10 million).

    ---------------------------------------------------------------------------

    The Commissions have determined that CFTC Regulation Sec.

    1.3(m)(8) is in the public interest in that it will make available a

    category of counterparty (i.e., swap dealers) that likely would not

    otherwise be available, and help to assure that sophisticated,

    professional managers operating qualifying Forex Pools can continue to

    engage in retail forex transactions. The Commissions have determined

    that the conditions of CFTC Regulation Sec. 1.3(m)(8) are sufficient

    for the protection of investors for the reasons discussed above, such

    as a significant reduction in the incidence of Forex Pool misconduct

    among CPOs, whether registered as such or exempt therefrom, operating

    Forex Pools with more than $10 million in total assets. The Commissions

    intend to monitor developments in the Forex Pool area and will revisit

    the conditions of this regulation as warranted by subsequent events.

    IV. Definitions of ``Major Swap Participant'' and ``Major Security-

    Based Swap Participant''

    The statutory definitions of ``major swap participant''\750\ and

    ``major security-based swap participant''\751\ (collectively, ``major

    participant'') encompass any person that is not a swap dealer or

    security-based swap dealer \752\ and that satisfy any one of three

    alternative statutory tests that encompass a person: (i) That maintains

    a ``substantial position'' in swaps or security-based swaps for any of

    the major swap categories as determined by the Commissions; (ii) whose

    outstanding swaps or security-based swaps create substantial

    counterparty exposure that could have serious adverse effects on the

    financial stability of the U.S. banking system or financial

    markets;\753\ or (iii) that is a ``financial entity'' that is ``highly

    leveraged'' relative to the amount of capital it holds (and that is not

    subject to capital requirements established by an appropriate Federal

    banking agency) and maintains a ``substantial position'' in outstanding

    swaps or security-based swaps in any major category as determined by

    the Commissions.\754\ The first--and only the first--of those three

    statutory tests explicitly excludes: (i) Positions held for ``hedging

    or mitigating commercial risk,'' and (ii) positions maintained by any

    employee benefit plan as defined in sections 3(3) and (32) of ERISA for

    the ``primary purpose of hedging or mitigating any risk directly

    associated with the operation of the plan.''\755\

    ---------------------------------------------------------------------------

    \750\ CEA section 1a(33).

    \751\ Exchange Act section 3(a)(67).

    \752\ As discussed above, a person may be designated as a dealer

    for particular activities involving swaps or security-based swaps,

    or particular swap or security-based swap activities, without being

    deemed to be a dealer with regard to other categories or activities.

    See part II.E, supra. To the extent that a person is subject to that

    type of limited designation as a swap dealer or security-based swap

    dealer, the person may be subject to being a major swap participant

    or a major security-based swap participant in connection with

    positions that fall outside of that limited dealer designation.

    \753\ See CEA section 1a(33)(A)(ii); Exchange Act section

    3(a)(67)(A)(ii)(II).

    \754\ See CEA section 1a(33)(A)(iii); Exchange Act section

    3(a)(67)(A)(ii)(III).

    \755\ See CEA section 1a(33)(A)(i); Exchange Act section

    3(a)(67)(A)(ii)(I).

    ---------------------------------------------------------------------------

    The statutory definitions require the Commissions to define the

    term ``substantial position'' at the threshold determined to be prudent

    for the effective monitoring, management, and oversight of entities

    that are systematically important or can significantly impact the

    financial system of the U.S. In setting these thresholds, the

    Commissions are required to consider the person's relative position in

    uncleared as opposed to cleared swaps and may take into consideration

    the value and quality of collateral held against counterparty

    exposures.\756\

    ---------------------------------------------------------------------------

    \756\ See CEA section 1a(33)(B) and Exchange Act section

    3(a)(67)(B).

    ---------------------------------------------------------------------------

    The statutory definitions further permit the Commissions to limit

    the scope of the major participant designations so that a person may be

    designated as a major participant in certain categories of swaps or

    security-based swaps, but not all categories.\757\

    ---------------------------------------------------------------------------

    \757\ See CEA section 1a(33)(C); Exchange Act section

    3(a)(67)(C).

    ---------------------------------------------------------------------------

    In addition, the ``major swap participant'' definition excludes

    certain entities whose primary business is providing financing and that

    use derivatives for the purpose of hedging underlying commercial risks

    related to interest rate and foreign currency exposures, 90 percent or

    more of which arise from financing that facilitates the purchase or

    lease of products, 90 percent or more of which are manufactured by the

    parent company or another subsidiary of the parent company.\758\ The

    ``major security-based swap participant'' definition does not contain

    this type of exclusion.

    ---------------------------------------------------------------------------

    \758\ See CEA section 1a(33)(D).

    ---------------------------------------------------------------------------

    As detailed in the Proposing Release, the major participant

    definitions focus on the market impacts and risks associated with a

    person's swap and security-based swap positions.\759\ This is in

    contrast to the definitions of ``swap dealer'' and ``security-based

    swap dealer,'' which focus on a person's activities and account for the

    amount or significance of those activities only in the context of the

    de minimis exception. However, persons that meet the major participant

    definitions in large part must follow the same statutory requirements

    that will apply to swap dealers and security-based swap dealers.\760\

    In this way, the statute applies comprehensive regulation to entities

    whose swap or security-based swap activities do not cause them to be

    dealers, but nonetheless could pose a high degree of risk to the U.S.

    financial system generally.\761\

    ---------------------------------------------------------------------------

    \759\ See Proposing Release, 75 FR at 80185.

    \760\ In particular, under CEA section 4s and Exchange Act

    section 15F, dealers and major participants in swaps or security-

    based swaps generally are subject to the same types of margin,

    capital, business conduct and certain other requirements, unless an

    exclusion applies. See CEA section 4s(h)(4), (5); Exchange Act

    section 15F(h)(4), (5). See also CFTC, Business Conduct Standards

    for Swap Dealers and Major Swap Participants with Counterparties;

    Final Rule, 77 FR 9733 (Feb. 17, 2012); Notice of Proposed

    Rulemaking: Capital requirements of swap dealers and major swap

    participants, 76 FR 27802 (May 12, 2011); and SEC, Notice of

    Proposed Rulemaking: Business Conduct Standards for Security-Based

    Swap Dealers and Major Security-Based Swap Participants, Securities

    Exchange Act Release No. 64766, 76 FR 42396 (July 18, 2011).

    \761\ As discussed below, the tests of the major participant

    definitions use terms--particularly ``systemically important,''

    ``significantly impact the financial system'' or ``create

    substantial counterparty exposure''--that denote a focus on entities

    that pose a high degree of risk through their swap and security-

    based swap activities. In addition, the link between the major

    participant definitions and risk was highlighted during the

    Congressional debate on the statute. See 156 Cong. Rec. S5907 (daily

    ed. July 15, 2010) (colloquy between Senators Hagen and Lincoln,

    discussing how the goal of the major participant definitions was to

    ``focus on risk factors that contributed to the recent financial

    crisis, such as excessive leverage, under-collateralization of swap

    positions, and a lack of information about the aggregate size of

    positions'').

    ---------------------------------------------------------------------------

    Although the two major participant definitions are similar, they

    address instruments that reflect different types of risks and that can

    be used by end-users and other market participants for

    [[Page 30662]]

    different purposes. Interpretation of the definitions must account for

    those differences as appropriate.

    The Commissions in the Proposing Release proposed to further define

    the ``major swap participant'' and ``major security-based swap

    participant'' definitions, by specifically addressing: (i) The

    ``major'' categories of swaps or security-based swaps; (ii) the meaning

    of ``substantial position''; (iii) the meaning of ``hedging or

    mitigating commercial risk''; (iv) the meaning of ``substantial

    counterparty exposure that could have serious adverse effects on the

    financial stability of the United States banking system or financial

    markets''; and (v) the meanings of ``financial entity'' and ``highly

    leveraged.'' The proposal also addressed the period of time that a

    major participant would have to register (as well as the minimum length

    of time for being a major participant), the limited purpose

    designations of major participants, the exclusion for ERISA plan

    hedging positions, and certain additional interpretive issues.

    After considering commenters' views, the Commissions are adopting

    final rules further defining the meaning of major participant.

    As discussed below, the Commissions also are directing their

    respective staffs to report separately as to whether changes are

    warranted to any of the rules implementing the major participant

    definitions. These staff reports will help the Commissions evaluate the

    ``major swap participant and ``major security-based swap participant''

    definitions, including whether new or revised tests or approaches would

    be appropriate for identifying major participants.\762\

    ---------------------------------------------------------------------------

    \762\ See part V, infra.

    ---------------------------------------------------------------------------

    A. ``Major'' Categories of Swaps and Security-Based Swaps

    1. Proposed Approach

    The first and third tests of the statutory major participant

    definitions encompass entities that maintain a substantial position in

    a ``major'' category of swaps or security-based swaps.\763\

    ---------------------------------------------------------------------------

    \763\ See CEA section 1a(33)(A)(i), (iii); Exchange Act section

    3(a)(67)(a)(2)(i), (iii).

    ---------------------------------------------------------------------------

    In the Proposing Release, the Commissions proposed to designate

    four ``major'' categories of swaps and two ``major'' categories of

    security-based swaps. These categories sought to reflect the risk

    profiles of the various types of swaps and security-based swaps, and

    the different purposes for which end-users use those instruments. The

    Proposing Release also noted the importance of not parsing the

    ``major'' categories so finely as to base the ``substantial position''

    thresholds on unduly narrow risks and reduce those thresholds'

    effectiveness as risk measures.\764\

    ---------------------------------------------------------------------------

    \764\ See Proposing Release, 75 FR at 80186-87.

    ---------------------------------------------------------------------------

    The proposed four ``major'' categories of swaps were rate swaps,

    credit swaps, equity swaps and other commodity swaps.\765\ Rate swaps

    would encompass any swap which is primarily based on one or more

    reference rates, such as swaps of payments determined by fixed and

    floating interest rates, currency exchange rates, or other monetary

    rates. Credit swaps would encompass any swap that is primarily based on

    default, bankruptcy and other credit-related risks related to, or the

    total returns on, instruments of indebtedness (including loans),

    including but not limited to any swap primarily based on one or more

    broad-based indices related to debt instruments, and any swap that is a

    broad-based index credit default swap or total return swap. Equity

    swaps would encompass any swap that is primarily based on equity

    securities, such as any swap primarily based on one or more broad-based

    indices of equity securities, including any total return swap on one or

    more broad-based equity indices. Other commodity swaps would encompass

    any swap not included in any of the first three categories, and would

    generally include, for example and not by way of limitation, any swap

    for which the primary underlying item is a physical commodity or the

    price or any other aspect of a physical commodity. The four categories

    were intended to cover all swaps, and each swap would be in the

    category that most closely describes the primary item underlying the

    swap.\766\

    ---------------------------------------------------------------------------

    \765\ See proposed CFTC Regulation Sec. 1.3(iii).

    \766\ The statutory definition of ``swap'' lists 22 different

    types of swaps.

    ---------------------------------------------------------------------------

    The Commissions proposed to designate two ``major'' categories of

    security-based swaps.\767\ The first category would encompass any

    security-based swap that is based, in whole or in part, on one or more

    instruments of indebtedness (including loans), or a credit event

    relating to one or more issuers or securities, including but not

    limited to any security-based swap that is a credit default swap, total

    return swap on one or more debt instruments, debt swaps, or debt index

    swaps. The second category would encompass any other security-based

    swaps not included in the first category, including for example, swaps

    on equity securities or narrow-based security indices comprised of

    equity securities.\768\ These proposed categories were based on the

    different uses of these types of security-based swaps, and were

    consistent with market statistics and infrastructures that distinguish

    between those types of security-based swaps.\769\

    ---------------------------------------------------------------------------

    \767\ See proposed Exchange Act rule 3a67-2.

    \768\ The second category also encompasses all security-based

    swaps on narrow based indices that are comprised of both debt and

    equity components.

    \769\ See Proposing Release, 75 FR at 80187.

    ---------------------------------------------------------------------------

    2. Commenters' Views

    Certain commenters requested clarification regarding how the major

    categories would be applied. One commenter particularly requested

    additional clarity as to how the proposed categories will apply to

    mixed swaps and to swaps that are based on debt that is convertible to

    equity,\770\ while another commenter requested additional clarity as to

    the status of certain mortgage-related transactions.\771\

    ---------------------------------------------------------------------------

    \770\ See letter from ISDA I.

    \771\ See letter from Freddie Mac.

    ---------------------------------------------------------------------------

    One commenter suggested that the final rules should include a

    catch-all provision to allow the Commissions to review large positions

    that appear to be structured to evade proper categorization, and that

    market participants should suggest the protocols for categorization of

    swaps or security-based swaps.\772\

    ---------------------------------------------------------------------------

    \772\ See meeting with Professor Darrell Duffie, Stanford

    University Graduate School of Business (``Duffie'') on February 2,

    2011.

    ---------------------------------------------------------------------------

    One commenter suggested that the rate swap category should be

    divided between interest rates and currencies, and that energy,

    agriculture and metals swaps should be separate categories.\773\

    Another commenter expressed the view that creation of a separate

    category for cross currency swaps could lead to confusion among market

    participants who may feel obligated to bifurcate cross currency swaps

    between two categories.\774\ Some commenters expressed general support

    for the major categories as proposed.\775\

    ---------------------------------------------------------------------------

    \773\ See letter from Better Markets I.

    \774\ See letter from ACLI.

    \775\ See letters from Barnard, ISDA I and MetLife; see also

    letter from American Insurance Association (``AIA'') (agreeing that

    the defined major categories would cover substantially all

    significant swaps and security-based swaps).

    ---------------------------------------------------------------------------

    3. Final Rules

    After considering the issue in light of comments received, the

    Commissions are adopting final rules designating ``major'' categories

    of swaps and security-based swaps consistent with the proposal.

    Accordingly, the final rules provide that the four ``major'' categories

    of swaps are rate swaps,

    [[Page 30663]]

    credit swaps, equity swaps and other commodity swaps.\776\ The two

    ``major'' categories of security-based swaps are debt security-based

    swaps \777\ and other security-based swaps.\778\

    ---------------------------------------------------------------------------

    \776\ See CFTC Regulation Sec. 1.3(iii). The four major

    categories of swaps are the same as the asset classes used in the

    CFTC Regulations relating to SDRs and reporting, except that the

    asset classes for interest rate swaps and foreign exchange

    transactions are combined into the single rate swap major category

    of swaps. See CFTC, Swap Data Repositories: Registration Standards,

    Duties and Core Principles; Final Rule, 76 FR 54538 (Sept. 1, 2011)

    and Swap Data Recordkeeping and Reporting Requirements; Final Rule,

    77 FR 2136 (Jan. 13, 2012).

    \777\ The name of the first major category of security-based

    swaps has been changed to ``debt security-based swaps'' in this

    Adopting Release from ``security-based credit derivatives'' in the

    Proposing Release. This change more accurately reflects the products

    encompassed by this category, particularly total return swaps on

    debt instruments. See Exchange Act rule 3a67-2(a).

    In addition, the final rules defining the major categories for

    purposes of the major participant definitions remove a cross-

    reference to the corresponding dealer definitions under the CEA or

    the Exchange Act to clarify that the rules apply only in the context

    of the major participant definitions, and not the dealer

    definitions. See CFTC Regulation Sec. 1.3(iii); Exchange Act rule

    3a67-2.

    \778\ See Exchange Act rule 3a67-2(b).

    ---------------------------------------------------------------------------

    The Commissions believe that it is not necessary to further divide

    the proposed categories or add new categories for swaps and security-

    based swaps for purposes of the major participant definitions. We

    believe that maintaining a large number of narrow categories of swaps

    and security-based swaps would increase the possibility of confusion by

    market participants with regard to categorizing the swaps and security-

    based swaps in which they transact. The Commissions also continue to

    believe that it is important not to parse the ``major'' categories so

    finely as to base the ``substantial position'' thresholds on unduly

    narrow groupings that would reduce those thresholds' effectiveness as

    risk measures. Categories that are broad and clearly delineated further

    should help prevent action to evade designation as a major participant

    in a particular ``major'' category.

    While we believe that these rules in general are sufficiently clear

    to allow each swap and security-based swap to be placed in the

    appropriate category, we are mindful of the commenters' request for

    guidance with regard to certain circumstances. In the case of mixed

    swaps, we would expect that the instrument would be placed in the

    ``swap'' and ``security-based swap'' categories that are consistent

    with the underlying attributes that cause such instrument to be a mixed

    swap.\779\ Also, swaps or security-based swaps that are based on more

    than one item, instrument or risk, should be placed in the category

    that most closely describes the primary item, instrument or risk

    underlying the swap or security-based swap.\780\

    ---------------------------------------------------------------------------

    \779\ The Commissions have proposed rules regarding the

    regulation of mixed swaps. See Product Definitions Proposal, note 3,

    supra.

    \780\ In the case of instruments on debt securities that are

    convertible into equity, in general we would expect the instrument

    to be categorized based on its status (as debt or equity) at the

    time of evaluation.

    ---------------------------------------------------------------------------

    B. ``Substantial Position''

    1. Proposed Approach

    The major participant definitions require that the Commissions

    define a ``substantial position'' in swaps or security-based swaps at a

    threshold that we determine to be ``prudent for the effective

    monitoring, management, and oversight'' of entities that are

    systemically important or can significantly impact the U.S. financial

    system. The definitions further require that we consider a person's

    relative position in uncleared and cleared swaps or security-based

    swaps, and permit us to consider the value and quality of collateral

    held against counterparty exposure.\781\

    ---------------------------------------------------------------------------

    \781\ See CEA section 1a(33)(B); Exchange Act section

    3(a)(67)(B).

    ---------------------------------------------------------------------------

    The proposed rules provided that a person would have a

    ``substantial position'' in swaps or security-based swaps if the daily

    average current uncollateralized exposure associated with its swap or

    security-based swap positions in a major category in a calendar quarter

    amounted to $1 billion or more (or $3 billion in the case of rate

    swaps).\782\ A person also would have a ``substantial position'' if the

    daily average of the sum of the current uncollateralized exposure plus

    the potential future exposure associated with its positions in a major

    category in a calendar quarter amounted to $2 billion or more (or $6

    billion for the rate swap category).\783\

    ---------------------------------------------------------------------------

    \782\ See proposed CFTC Regulation Sec. 1.3(jjj)(1); proposed

    Exchange Act rule 3a67-3(a)(1), (d).

    \783\ See proposed CFTC Regulation Sec. 1.3(jjj)(1); proposed

    Exchange Act rule 3a67-3(a)(2), (d).

    ---------------------------------------------------------------------------

    The proposed rules did not prescribe any particular methodology for

    measuring current exposure or valuing collateral posted, and instead

    provided that the method used should be consistent with counterparty

    practices and industry practices generally.\784\ The proposed rules

    also provided that an entity could calculate its current

    uncollateralized exposure by accounting for netting agreements on a

    counterparty-by-counterparty basis,\785\ and the Proposing Release set

    forth a method for allocating any residual uncollateralized exposure to

    a counterparty that remains following netting.\786\

    ---------------------------------------------------------------------------

    \784\ See proposed CFTC Regulation Sec. 1.3(jjj)(2)(ii);

    proposed Exchange Act rule 3a67-3(a)(2)(i).

    \785\ See proposed CFTC Regulation Sec. 1.3(jjj)(2)(iii);

    proposed Exchange Act rule 3a67-3(b)(3).

    \786\ See Proposing Release, 75 FR at 80190.

    ---------------------------------------------------------------------------

    The proposed potential future exposure test was based on the risk-

    adjusted notional amount of the entity's swap and security-based swap

    positions, consistent with a test used by bank regulators for purposes

    of setting capital standards.\787\ The test also excluded or lowered

    the potential exposure associated with certain lower-risk

    positions.\788\ In addition, the measures of potential future exposure

    would be discounted by up to 60 percent to reflect the risk mitigation

    provided by netting agreements,\789\ and would further be decreased by

    80 percent for positions subject to central clearing or daily mark-to-

    market margining.\790\

    ---------------------------------------------------------------------------

    \787\ See id. at 80191-92.

    \788\ See proposed CFTC Regulation Sec. 1.3(jjj)(3)(iii);

    proposed Exchange Act rule 3a67-3(c)(2)(i)(C), (D).

    \789\ See proposed CFTC Regulation Sec. 1.3(jjj)(3)(ii)(B);

    proposed Exchange Act rule 3a67-3(c)(2)(ii).

    \790\ See proposed CFTC Regulation Sec. 1.3 (jjj)(3)(iii)(A);

    proposed Exchange Act rule 3a67-3(c)(3)(i). This discount for daily

    margining would be available even in the presence of a threshold or

    a minimum transfer amount, so long as the threshold and the minimum

    transfer amount (if the latter exceeds $1 million) are separately

    added to the entity's current exposure for purposes of the current

    exposure plus potential future exposure test. See proposed CFTC

    Regulation Sec. 1.3(jjj)(3)(iii)(B); proposed Exchange Act rule

    3a67-3(c)(3)(ii).

    ---------------------------------------------------------------------------

    2. Commenters' Views

    a. Basis for Regulating Major Participants and Alternative Approaches

    for Identifying ``Substantial Positions''

    Several commenters expressed the view that the major participant

    definition is intended to address entities whose swap or security-based

    swap positions pose systemic risk,\791\ while one commenter took the

    contrary view that the definition also is intended to address the

    significance of an entity's swap or security-based swap positions (as

    well as the risk those positions pose).\792\

    ---------------------------------------------------------------------------

    \791\ E.g., letters from BlackRock I and MFA I.

    \792\ See letter from Better Markets I.

    ---------------------------------------------------------------------------

    One commenter stated that the proposal inappropriately sought to

    account for the risk posed by the potential default of multiple

    entities, rather than a single entity.\793\ Some commenters suggested

    that the analysis should account for the concentration of the risk

    posed by an entity's

    [[Page 30664]]

    positions,\794\ and one commenter suggested that the analysis should

    not account for individual categories of swaps or security-based

    swaps.\795\

    ---------------------------------------------------------------------------

    \793\ See letter from BlackRock I.

    \794\ See letters from Black Rock I (suggesting a two-step

    process that accounts for the reduced risk associated with entities

    whose positions are distributed among several counterparties); CCMR

    I and APG Algemene Pensioen Groep NV (``APG'').

    \795\ See letter from NYCBA Committee.

    ---------------------------------------------------------------------------

    b. Levels of Proposed ``Substantial Position'' Thresholds

    A number of commenters expressed the view that the proposed

    thresholds are inappropriately low.\796\ Some commenters stated the

    thresholds initially should be high, with later revisions based on

    market data.\797\

    ---------------------------------------------------------------------------

    \796\ See letters from ABC/CIEBA (indirectly referring to AIG

    Financial Products, and noting that it had $400 billion in notional

    positions and defaulted when it was required to post approximately

    $100 billion in collateral); BG LNG I (alluding to lack of systemic

    impact associated with Enron's failure, and suggesting that the

    Commissions convene an advisory committee to develop thresholds);

    NCGA/NGSA I (alluding to corporate financial losses involving

    derivatives that have exceeded the proposed thresholds without

    significantly impacting the U.S. financial system); ACLI (supporting

    increase in proposed thresholds under the CEA to $4 billion current

    uncollateralized exposure and $8 billion current uncollateralized

    exposure plus potential future exposure); and Chesapeake Energy.

    \797\ See letters from MFA dated February 25, 2011 (``MFA II'')

    (stating that thresholds initially should be set higher, while later

    survey-based thresholds should be based on potential systemic risk

    impact and the cost of performing the calculations); CCMR I (stating

    that the Commissions presently have insufficient data to determine

    appropriate thresholds, and that thresholds initially should be

    high); BlackRock I (stating that the Commissions should refrain from

    establishing thresholds if sufficient information is not available);

    and Freddie Mac. Two commenters particularly addressed the proposed

    thresholds applicable to rate swaps. See letters from ACLI and

    MetLife.

    ---------------------------------------------------------------------------

    Some commenters did not oppose the proposed thresholds or expressed

    support for the thresholds (though many of those commenters separately

    raised issues about the underlying tests),\798\ while two commenters

    supported lowering the proposed thresholds.\799\ Some commenters took

    the position that the thresholds should be adjusted over time to

    reflect factors such as inflation or market characteristics.\800\

    ---------------------------------------------------------------------------

    \798\ See, e.g., letters from ACLI, Fidelity, SIFMA AMG dated

    Feb. 22, 2011 (``SIFMA AMG II'') and Vanguard (supporting proposed

    limits for credit swaps, equity swaps and other commodity swaps, but

    not rate swaps).

    \799\ See letters from AFR (supporting use of a $500 million

    uncollateralized exposure threshold, or a $1 billion current

    exposure plus potential future exposure threshold, with higher

    thresholds for rate swaps) and Greenberger.

    \800\ See, e.g., letters from MFA I (referring to inflation and

    measures such as the amount of equity in the U.S. banking system)

    and ISDA I (referring to evolution of the size and fundamental

    characteristics of the markets, and changes to valuation

    methodologies and economic conditions).

    ---------------------------------------------------------------------------

    c. Current Uncollateralized Exposure Test

    Measures of exposure and valuation of collateral--A number of

    commenters supported the Proposing Release's position that the current

    exposure analysis not prescribe any methodology for measuring exposure

    or valuing collateral.\801\ On the other hand, some commenters

    requested explicit approval of particular methodologies,\802\ a good

    faith safe harbor,\803\ or regulator-prescribed measurement

    standards.\804\ Some commenters emphasized the need to be able to post

    non-cash collateral in connection with positions.\805\ Two commenters

    requested codification of the proposal's position that operational

    delays associated with the daily exchange of collateral would not lead

    to current uncollateralized exposure for purposes of the analysis.\806\

    ---------------------------------------------------------------------------

    \801\ See letters from Fidelity, ICI I, ISDA I and MFA I.

    \802\ See letter from BlackRock I. Consistent with the proposal,

    the final rules contemplate the use of industry standard practices

    in the calculation of current exposure and potential future

    exposure. As with other rules adopted by the Commissions, a market

    participant may raise questions with the Commissions about the

    participant's approach to addressing the final rules--including its

    use of particular methodologies--for further guidance as may be

    necessary or appropriate.

    \803\ See letter from FSR I (particularly noting difficulty of

    valuing illiquid or bespoke positions).

    \804\ See letter from Better Markets I.

    \805\ See, e.g., letters from ACLI, CDEU and MetLife.

    \806\ See letters from SIFMA AMG II and Vanguard.

    ---------------------------------------------------------------------------

    Netting issues--Some commenters stated that the proposed netting

    provisions should be expanded to encompass additional products that may

    be netted for bankruptcy purposes.\807\ One commenter took the view

    that these provisions should be expanded across multiple netting

    agreements to the extent that offsets are permitted.\808\ One commenter

    asked for clarification as to the scope of the netting provisions,\809\

    and one commenter expressed general support for the proposed netting

    provisions.\810\

    ---------------------------------------------------------------------------

    \807\ See letters from ISDA I (specifically addressing

    securities contracts and forward contracts); NRG Energy

    (specifically addressing forwards); and APG (specifically addressing

    securities options and forwards).

    \808\ See letter from FSR I.

    \809\ See letter from Fidelity (seeking confirmation that

    ``master netting agreement'' can include an ISDA Master Agreement).

    \810\ See letter from ACLI.

    ---------------------------------------------------------------------------

    Allocation of uncollateralized exposure--Some commenters requested

    that the final rules incorporate the principles, articulated in the

    Proposing Release, for allocating any uncollateralized exposure that

    remains following netting.\811\ Other commenters raised concerns that

    those principles were based on an unwarranted assumption that

    collateral is specifically earmarked to particular transactions.\812\

    ---------------------------------------------------------------------------

    \811\ See letters from SIFMA AMG II and Vanguard.

    \812\ See letters from FSR I and ISDA I; see also letter from

    MetLife (suggesting pro rata allocation of uncollateralized current

    exposure among each major category with current exposure).

    ---------------------------------------------------------------------------

    d. Potential Future Exposure Test

    General concerns and suggested alternative approaches--Some

    commenters disagreed with the Proposing Release's statement that the

    potential future exposure analysis would evaluate potential changes in

    the value of a swap or security-based swap over the remaining life of

    the contract; those commenters stated that the test instead should

    focus on potential volatility during the time it would take for a non-

    defaulting party to close out a defaulting party's positions.\813\

    ---------------------------------------------------------------------------

    \813\ See letters from SIFMA AMG II and Vanguard.

    ---------------------------------------------------------------------------

    Some commenters criticized the tables setting forth the risk

    adjustments used to calculate potential future exposure.\814\

    Commenters further suggested using, as alternatives, value-at-risk

    measures or other models,\815\ or the ``standardized method'' under

    Basel II.\816\ Commenters also argued that risk adjustments should

    provide a greater discount to credit swaps on ``investment grade''

    instruments than to other credit swaps, that index CDS should be

    subject to a greater discount than single name CDS, and that there

    should be a lower discount factor for CDS of shorter maturity.\817\ One

    commenter generally supported the proposed conversion factors and

    adjustments.\818\

    ---------------------------------------------------------------------------

    \814\ See letters from Riverside Risk Advisors LLC (``Riverside

    Risk Advisors'') (criticizing, among other aspects, discontinuities

    in table, a failure to account for how far a swap is in or out of

    the money, the use of a single discount factor for credit default

    swaps, the fact that the risk factor for short-term equity swaps is

    lower than the risk factor for credit swaps, and the fact that

    equity swaps do not distinguish between high-volatility and low-

    volatility stocks, as well as the failure to address portfolio

    effects of diversification and correlation, and ``wrong-way'' risk

    in the form of ``an adverse correlation between counterparty default

    risk and the value of its derivatives contracts''); and ISDA I

    (noting that the conversion factors were calibrated more than 15

    years ago and were not designed for later instruments such as credit

    products).

    \815\ See letters from Riverside Risk Advisors (supporting

    giving end-users the option to use a model-based approach); and

    Better Markets I (supporting use of a value-at-risk calculation).

    \816\ See letter from ISDA I.

    \817\ See letters from AIMA I and MFA I.

    \818\ See letter from MetLife.

    ---------------------------------------------------------------------------

    Some commenters expressed the view that measures of potential

    future exposure should be superseded by negotiated independent amounts

    or regulator-required initial margin.\819\ Some commenters also argued

    that

    [[Page 30665]]

    excess posted collateral or net in-the-money positions should be offset

    against potential future exposure.\820\

    ---------------------------------------------------------------------------

    \819\ See letters from SIFMA AMG II and Vanguard.

    \820\ See, e.g., letters from AIMA I, Fidelity, MFA I, SIFMA AMG

    II and Vanguard.

    ---------------------------------------------------------------------------

    Potential future exposure measures for lower-risk positions--Some

    commenters stated that the proposal to cap potential future exposure

    when a person buys credit protection using a credit default swap should

    be expanded to apply to any position with a fixed downside risk.\821\

    Commenters also suggested that the potential future exposure associated

    with purchases of credit protection be further discounted,\822\ while

    one commenter took the position that purchases of credit default swaps

    should be excluded from the potential future exposure test.\823\

    Commenters also addressed the appropriate discount rate for calculating

    the net present value of unpaid premiums.\824\

    ---------------------------------------------------------------------------

    \821\ See letters from MFA I (citing fixed portions of interest

    rate swaps), MetLife (citing purchased options as well as CDS), ACLI

    and Ropes & Gray.

    \822\ See letters from MFA I (arguing that the tightening of

    credit spreads would imply a healthy credit environment) and AIMA;

    see also meeting with MFA on February 14, 2011.

    \823\ See letter from Vanguard.

    \824\ See letter from MFA I (suggesting the possible use of the

    LIBOR/Swap rate) and AIMA I.

    ---------------------------------------------------------------------------

    Netting issues--One commenter stated that the proposal's netting

    provisions did not adequately account for the risk mitigation

    associated with hedged positions,\825\ while another commenter asked

    that the proposed netting provisions be clarified and simplified.\826\

    One commenter supported the proposed netting approach.\827\

    ---------------------------------------------------------------------------

    \825\ See letter from ISDA I.

    \826\ See letter from SIFMA AMG II.

    \827\ See letters from ACLI.

    ---------------------------------------------------------------------------

    Discount for cleared or margined positions--Several commenters took

    the view that cleared positions should be excluded entirely from the

    potential future exposure analysis, rather than only being subject to

    an 80 percent discount,\828\ and some commenters also supported a

    complete exclusion for positions subject to daily mark-to-market

    margining.\829\ One commenter suggested a minimum 98 percent reduction

    for positions subject to central clearing or mark-to-market

    margining,\830\ while one commenter suggested that there be a higher

    discount for positions subject to the posting of initial margin.\831\

    ---------------------------------------------------------------------------

    \828\ See, e.g., letters from MFA I, SIFMA AMG II and Vanguard.

    \829\ See letters from BG LNG I, Fidelity and ICI I.

    \830\ See letter from ISDA I.

    \831\ See letter from FHLB I (suggesting 90 percent discount for

    cleared swaps and for uncleared swaps for which initial margin has

    been posted; alternatively suggesting that posted initial margin be

    subtracted from the calculated amount).

    ---------------------------------------------------------------------------

    Some commenters also stated that there should be a partial discount

    provided in connection with positions for which mark-to-market

    margining is done less than daily,\832\ and that there should be a

    discount for positions that are margined using security interests or

    liens.\833\ On the other hand, one commenter stated that there is no

    basis for providing any discount for marked-to-market positions.\834\

    ---------------------------------------------------------------------------

    \832\ See letters from Fidelity and Canadian Master Asset

    Vehicle I and Master Asset Vehicle II (``Canadian MAVs'').

    \833\ See letter from FHLB I (giving as an example swaps

    collateralized by security interests in real estate, oil or gas

    interests, or by first liens on financial assets).

    \834\ See letter from Better Markets I; see also letter from AFR

    (generally opposing use of risk adjustments, but suggesting that any

    such discounts should be larger for cleared positions).

    ---------------------------------------------------------------------------

    One commenter requested that the rule language codify language in

    the Proposing Release as to when a position is subject to daily mark-

    to-market margining.\835\ A number of commenters addressed proposed

    rule language that was intended to clarify that the discount for daily

    mark-to-market margining would be available even in the presence of

    thresholds and minimum transfer amounts.\836\

    ---------------------------------------------------------------------------

    \835\ See letter from SIFMA AMG II.

    \836\ See letter from CDEU (stating that the proposal could

    overstate an entity's future exposure, and favoring use of the lower

    of the calculated potential future exposure or the CSA threshold);

    see also letters from SIFMA AMG II and Vanguard.

    ---------------------------------------------------------------------------

    Two commenters supported the proposed approach in general.\837\ One

    commenter specifically supported the proposed 80 percent reduction for

    positions subject to daily mark-to-market margining,\838\ and one

    commenter specifically supported a reduction for cleared

    positions.\839\

    ---------------------------------------------------------------------------

    \837\ See letters from ACLI and MetLife.

    \838\ See letter from Vanguard.

    \839\ See letter from Better Markets I.

    ---------------------------------------------------------------------------

    Additional issues regarding the potential future exposure test--

    Some commenters argued that the Commissions should clarify how the

    categories in the proposed potential future exposure tables would be

    applied, given how those differ from the proposed ``major'' categories

    of swaps and security-based swaps.\840\

    ---------------------------------------------------------------------------

    \840\ See letters from SIFMA AMG II and Vanguard.

    ---------------------------------------------------------------------------

    Some commenters raised concerns that the proposed use of an

    instrument's ``effective notional'' amount is ambiguous.\841\

    Commenters also took the position that for purposes of the potential

    future exposure calculation, notional amounts should be adjusted to

    reflect delta weighting,\842\ that the measure of duration for options

    on swaps should consider whether the underlying swap is cash-

    settled,\843\ and that the adopting release should set forth examples

    of potential future exposure calculations.\844\

    ---------------------------------------------------------------------------

    \841\ See letters from FSR I, SIFMA AMG II and Vanguard.

    \842\ See letters from MFA I and Ropes & Gray.

    \843\ See letter from MFA I.

    \844\ See id.

    ---------------------------------------------------------------------------

    e. Cost Concerns

    Some commenters emphasized the need to avoid an overbroad major

    participant definition, \845\ and highlighted concerns about being

    subject to unnecessary regulation.\846\

    ---------------------------------------------------------------------------

    \845\ See joint letter from Representatives Bachus and Lucas.

    \846\ See, e.g., letters from SIFMA AMG II (stating that the

    commenter's suggested changes in connection with the substantial

    position analysis would reduce burdens and costs to market

    participants, and more closely align the tests with the objectives

    they are meant to achieve) and ABC/CIEBA; see also letter from

    NFPEEU (reserving the right to dispute the cost-benefit analysis

    associated with the proposed dealer and major participant rules

    until all relevant Dodd-Frank Act releases could be analyzed as a

    whole).

    ---------------------------------------------------------------------------

    f. Additional Issues

    One commenter suggested there be an explicit presumption against

    imposing major participant (or dealer) regulation on end-users.\847\

    Some commenters requested that the current uncollateralized exposure

    test explicitly exclude cleared positions, net in-the-money positions,

    and fully collateralized out-of-the-money positions,\848\ and one

    commenter also supported excluding those positions from the potential

    future exposure analysis.\849\ That commenter also supported excluding

    swaps on government securities from the substantial position

    analysis.\850\

    ---------------------------------------------------------------------------

    \847\ See letter from CDEU.

    \848\ See letters from ICI I, SIFMA AMG II and Vanguard.

    \849\ See letter from ICI I.

    \850\ See letter from ICI I (noting size of government security

    market and Federal Reserve control over supply and demand, and

    stating that the proposed thresholds are ill-suited to address the

    ``vast'' government securities market).

    ---------------------------------------------------------------------------

    One commenter requested confirmation that dealers and major

    participants would not be required to compute, assist with, or verify

    computations for counterparties that may be major participants, and

    also that market participants can enlist third-party services to assist

    in performing the calculations.\851\ One commenter requested

    clarification that the proposed focus on uncollateralized exposure does

    not mean that end-users themselves

    [[Page 30666]]

    should not demand collateral from dealers.\852\

    ---------------------------------------------------------------------------

    \851\ See letter from ISDA I.

    \852\ See letter from FHLB I.

    ---------------------------------------------------------------------------

    3. Final Rules

    a. Guiding Principles

    The final rules defining ``substantial position'' focus on

    identifying persons whose large swap and security-based swap positions

    pose market risks that are significant enough that it would be

    ``prudent'' to regulate those persons. In developing these rules we

    have been mindful of the costs associated with regulating major

    participants, and have considered cost and benefit principles as part

    of the analysis of what level of swap and security-based swap positions

    reasonably form the lower bounds for identifying when it would be

    ``prudent'' that particular entities be subject to monitoring,

    management and oversight of entities that may be systemically important

    or may significantly impact the U.S. financial system.\853\

    ---------------------------------------------------------------------------

    \853\ At the same time, as discussed above in the context of the

    de minimis exception to the dealer definitions, we are mindful that

    the benefits of financial regulation cannot be quantified. For

    example, while the regulation of major participants will comprise

    one component of Title VII's comprehensive regulatory framework that

    should be expected to help lessen the amount and frequency of

    financial crises, we cannot place a dollar figure on the

    contribution of major participant regulation to those benefits. In

    light of those factors, we believe that it would be ``prudent'' to

    regulate, as major participants, those persons whose swap or

    security-based swap positions are large enough to pose a material

    potential of causing significant counterparty impacts, consistent

    with the levels set forth in the final rules. The Commissions will

    further address the comparative costs and benefits associated with

    regulating major participants in the context of the substantive

    rules applicable to major participants.

    ---------------------------------------------------------------------------

    The final rules implementing the ``substantial position''

    definition follow the basic approach that the Commissions proposed,

    including the combined use of current exposure and potential future

    exposure tests.\854\ While we have carefully considered the views of

    commenters who suggested alternative approaches, we have concluded that

    it is appropriate to adopt the basic approach that was proposed, as

    described below.

    ---------------------------------------------------------------------------

    \854\ As with the proposal, the final rules apply these tests to

    swap and security-based swap positions in a ``major'' category. See

    CFTC Regulation Sec. 1.3(jjj)(1); Exchange Act rule 3a67-3(a). The

    final rules have been modified from the proposal, however, by

    removing a reference to ``positions excluded from consideration.''

    We have concluded that this reference is unnecessary because the

    first statutory major participant test explicitly provides that

    positions that are subject to the commercial risk hedging and the

    ERISA hedging exclusions of the first major participant test need

    not be considered for purposes of that test.

    ---------------------------------------------------------------------------

    Focus on default-related credit risks. The final rules

    implement tests that seek to reflect the credit risk that a person's

    swap or security-based swap positions would pose in the event of

    default. In arguing that the analysis should consider factors in

    addition to default-related risks, commenters have noted that certain

    regulations applicable to major participants address business conduct

    issues that are distinct from systemic risk issues.\855\ We nonetheless

    believe that the statutory definition of ``substantial position''

    indicates that the analysis should focus on default-related credit

    risks, because a default-related approach is more closely linked to the

    statutory criteria that the definition focus on entities that are

    ``systemically important'' or can ``significantly impact'' the U.S.

    financial system than would be an approach that focuses on the

    potential for disruptive market movements.\856\

    ---------------------------------------------------------------------------

    \855\ See, e.g., letter from Better Markets I.

    \856\ We also believe that the statutory definition should focus

    on all default-related credit risks associated with swap or

    security-based swap positions. We do not see a basis for excluding

    any class of risks (e.g., risks associated with swaps based on

    government securities) from the analysis.

    ---------------------------------------------------------------------------

    Failure of multiple entities close in time. The final

    rules that implement the ``substantial position'' definition seek to

    reflect the risks that would be posed by the default of multiple

    entities close in time. Although one commenter took the view that the

    purpose of major participant regulation is to prevent the credit

    exposure of a single person from having a systemic impact,\857\ we do

    not believe that the major participant definitions should be construed

    so narrowly. The events of recent years demonstrate that market stress

    may lead to the failure and near-failure of multiple entities with

    large financial positions over a relatively short time period. We do

    not believe that it would be prudent or well-reasoned to presume that

    recent history cannot repeat itself, and to assume that future failures

    of entities with large financial positions will be isolated events.

    ---------------------------------------------------------------------------

    \857\ See letter from BlackRock I.

    ---------------------------------------------------------------------------

    Aggregate risk. The final rules address the aggregate risk

    posed by an entity's swap or security-based swap positions, rather than

    seeking to focus on principles of concentration (such as by using a

    threshold that addresses an entity's largest exposure to an individual

    counterparty) or on converse principles of interconnection. The

    statutory ``substantial position'' definition is specifically written

    in terms of market risk concerns (i.e., ``systemically important'' and

    ``can significantly impact the financial system of the United

    States''), and measures of aggregate risk appear to be best geared to

    reflect this standard.\858\

    ---------------------------------------------------------------------------

    \858\ Moreover, a test that focuses on the concentration of an

    entity's swap or security-based swap exposure toward one or a few

    individual parties potentially poses a tension with the view that

    interconnections of exposure among multiple parties are important to

    establishing systemic risk.

    ---------------------------------------------------------------------------

    Use of objective, quantitative criteria. The final rules

    provide for a ``substantial position'' analysis that is based on

    objective, quantitative criteria that would permit a market participant

    to determine which level of swap or security-based swap positions would

    cause it to be a major participant. Although one commenter has

    suggested the use of a two-step approach that uses thresholds as a safe

    harbor and that would be accompanied by a second-level

    determination,\859\ we do not believe that such an approach would be

    consistent with the statutory language or with principles of regulatory

    efficiency.\860\ Accordingly, a person whose swap or security-based

    swap positions satisfy the applicable thresholds will be a major

    participant, with no further layer of review provided.\861\

    ---------------------------------------------------------------------------

    \859\ See letter from BlackRock I.

    \860\ The major participant definitions specifically require

    that the term ``substantial position'' be defined ``by rule or

    regulation'' via a ``threshold.'' That language would not appear to

    anticipate the use of a multi-tier approach that accounts for

    subjective criteria.

    In this respect, the major participant definitions may be

    compared with section 113 of the Dodd-Frank Act, which authorizes

    the Financial Stability Oversight Council (``FSOC'') to provide for

    a non-bank financial company to be supervised by the Board if the

    FSOC ``determines that material financial distress at the U.S.

    nonbank financial company, or the nature, scope, size, scale,

    concentration, interconnectedness, or mix of the activities of the

    U.S. nonbank financial company, could pose a threat to the financial

    stability of the United States.'' Section 113 further provides that

    these designations will result from a vote of the FSOC based on a

    variety of factors. The ``major participant'' definition does not

    provide for this type of entity-specific determination, and we

    believe that the ``major participant'' definition more appropriately

    is implemented by objective factors that allow market participants

    to determine whether they will fall within the definition.

    \861\ In addition, the final rules provide that the

    ``substantial position'' analysis that implements the first (and

    third) major participant test will be based on the ``major''

    categories of swaps and security-based swaps. Notwithstanding

    commenter concerns that this approach will require market

    participants to analyze their swaps and security-based swaps in new

    ways and will result in additional costs, this focus on ``major''

    categories is dictated by the plain language of the statute.

    ---------------------------------------------------------------------------

    b. Current Uncollateralized Exposure Test

    Consistent with the proposal, the final rules implementing the

    ``substantial position'' definition include a test that accounts for

    the current uncollateralized exposure posed by an entity's swap or

    security-based swap positions in a major

    [[Page 30667]]

    category.\862\ This provides a measure of the amount of potential risk

    that an entity would pose to its counterparties if the entity currently

    were to default.\863\

    ---------------------------------------------------------------------------

    \862\ CFTC Regulation Sec. 1.3(jjj)(1); Exchange Act rule 3a67-

    3(b)(2). The final rules contain technical changes from the proposal

    to clarify the steps entailed by this calculation.

    \863\ See Proposing Release, 75 FR at 80188.

    ---------------------------------------------------------------------------

    As with the proposal, a person would apply this test by examining

    the positions it maintains with each of its counterparties in a

    particular major category of swaps or security-based swaps. For each

    counterparty, the person would determine the dollar value of the

    aggregate current exposure arising from each of its swap or security-

    based swap positions with negative value in that major category by

    marking-to-market using industry standard practices, and deduct from

    that amount the aggregate value of the collateral the entity has posted

    with respect to the swap or security-based swap positions.\864\ The

    ``aggregate uncollateralized outward exposure'' would be the sum of

    those uncollateralized amounts over all counterparties with which the

    person has entered into swaps or security-based swaps in that major

    category.\865\

    ---------------------------------------------------------------------------

    \864\ As we noted in the Proposing Release, we recognize that

    there may be operational delays between changes in exposure and the

    resulting exchanges of collateral, and in general we would not

    expect that operational delays associated with the daily exchange of

    collateral would be considered to lead to uncollateralized exposure

    for these purposes. See Proposing Release, 75 FR at 80189 n.92.

    Although we are not codifying this principle within the final rules,

    we will be mindful of the principle when enforcing those rules.

    \865\ CFTC Regulation Sec. 1.3(jjj)(2); Exchange Act rule 3a67-

    3(b)(2).

    ---------------------------------------------------------------------------

    The final rules implementing this test largely are the same as the

    rules the Commissions proposed, but with certain modifications to

    address issues raised by commenters.

    i. Measure of Exposure and Valuation of Collateral

    Consistent with the proposal, the final rules do not prescribe any

    particular methodology for measuring current exposure or for valuing

    collateral posted, but instead require the use of industry standard

    practices.\866\ In this regard we do not concur with commenter requests

    that we approve or prescribe particular methodologies, or provide a

    safe harbor for measures or valuations made in good faith.\867\

    Instead, it is appropriate that the final rules provide market

    participants with the flexibility to use the same methodologies that

    they use in connection with their business activities. Accordingly, we

    would expect entities to value current uncollateralized exposure based

    on the amounts that would be payable if the transaction were

    terminated.

    ---------------------------------------------------------------------------

    \866\ CFTC Regulation Sec. 1.3(jjj)(2); Exchange Act rule 3a67-

    3(b)(1). As we noted in the Proposing Release, collateral may be

    posted to a third-party custodian, directly to the counterparty, or

    in accordance with the rules of a derivatives clearing organization

    or clearing agency. See Proposing Release, 75 FR at 80189 n.94.

    \867\ See letters from BlackRock I, Better Markets I and FSR I.

    ---------------------------------------------------------------------------

    To the extent the measure of exposure or the valuation of

    collateral is subject to other rules or regulations, we also would

    expect those measures and valuations for purposes of the major

    participant calculations to be consistent with those other applicable

    rules.\868\ In addition, the ``substantial position'' analysis may take

    into account the posting of non-cash collateral to the extent that the

    posting of such collateral, and the valuation of that collateral, is

    consistent with industry standard practices or applicable

    regulation.\869\

    ---------------------------------------------------------------------------

    \868\ These principles should apply even in the case of valuing

    illiquid or bespoke positions. Market participants have the

    flexibility to use commercially reasonable approaches that are

    consistent with their financial statements, tax calculations and

    compliance with other regulations.

    \869\ For non-cash collateral to be considered for purposes of

    these calculations, the collateral must be available for the

    counterparty's use if the entity posting the collateral were to

    default. At a minimum, this would require that the counterparty

    possess a perfected security interest in that collateral. As we

    noted in the Proposing Release, while we expect that other

    regulatory requirements applicable to the valuation of swap or

    security-based swap positions and collateral would be relevant to

    certain calculations relating to major participant status, these

    rules would not necessarily be relevant for other purposes, such as

    in the context of capital and margin requirements. See Proposing

    Release, 75 FR at 80189 n.95.

    ---------------------------------------------------------------------------

    ii. Netting

    The final rules build upon the proposal with regard to the measure

    of uncollateralized current exposure in the presence of netting

    arrangements. In particular, to address commenter concerns these

    provisions have been modified from the proposal to account for the fact

    that two counterparties may have multiple netting agreements for which

    offsets are permitted, and to extend the netting principles to any

    financial instruments that may be netted for purposes of applicable

    bankruptcy law (rather than limiting those instruments to swaps,

    security-based swaps and securities financing transactions).

    Accordingly, the final rules provide that an entity may calculate

    its exposure on a net basis by applying the terms of one or more master

    netting agreements with a counterparty. The entity may account for

    offsetting positions entered into with that particular counterparty

    involving swaps or security-based swaps as well as securities financing

    transactions (consisting of securities lending and borrowing,

    securities margin lending and repurchase and reverse repurchase

    agreements), and other financial instruments and agreements that are

    subject to netting offsets for purposes of applicable bankruptcy law,

    to the extent consistent with the offsets provided by those master

    netting agreements.\870\ These revisions should permit the current

    uncollateralized exposure test to more accurately reflect the degree of

    credit risk that an entity poses to its counterparty in the event of

    default.

    ---------------------------------------------------------------------------

    \870\ CFTC Regulation Sec. 1.3(jjj)(2)(iii); Exchange Act rule

    3a67-3(b)(3)(i). This provision provides for netting under the

    master netting agreement of any instruments, contracts or agreements

    (including contracts on physical commodities), that would qualify

    for netting under applicable bankruptcy law. As we noted in the

    Proposing Release, the proposed rules regarding possible offsets of

    various positions are for purposes of determining major participant

    status only. Other rules proposed by the Commissions may address the

    extent to which, if any, persons such as dealers and major

    participants may offset positions for other purposes. See Proposing

    Release, 75 FR at 80189 n.98. As proposed, Exchange Act rule 3a67-

    3(b)(3)(i) referred to ``security-based swaps (in any swap

    category)''; this reference has been revised in the final rule to

    ``security-based swaps (in any security-based category).''

    ---------------------------------------------------------------------------

    As discussed in the proposal, these netting provisions apply only

    to offsetting positions with a single counterparty.\871\ The provisions

    do not extend to the market risk offsets associated with an entity's

    positions with multiple counterparties, because such offsets would not

    directly mitigate the risks that an individual counterparty would face

    in the event of the entity's default.\872\

    ---------------------------------------------------------------------------

    \871\ CFTC Regulation Sec. 1.3(jjj)(2)(iii); Exchange Act rule

    3a67-3(b)(3)(ii).

    \872\ The fact that positions with third parties do not offset

    exposure to a particular counterparty was recently highlighted by a

    decision finding that the Bankruptcy Code does not permit excess

    collateral held by one creditor to offset amounts that the debtor

    owed to the creditor's affiliates. See In re Lehman Brothers Inc.,

    Case No. 08-01420 (JMP) (SIPA), slip op. (Bankr. S.D.N.Y Oct. 4,

    2011).

    ---------------------------------------------------------------------------

    iii. Allocation of Uncollateralized Exposure Following Netting

    The final rules build upon the proposal by codifying the method,

    discussed in the Proposing Release, related to the allocation of any

    uncollateralized exposure that remains following netting and the

    posting of collateral. This type of allocation can be necessary

    because, with netting, it otherwise may not be possible to directly

    attribute residual uncollateralized exposure to a particular major

    category of swap or security-based

    [[Page 30668]]

    swap.\873\ Some commenters have requested that the final rules codify

    this method to provide more certainty to market participants.\874\

    ---------------------------------------------------------------------------

    \873\ Such allocation would not be necessary, of course, to the

    extent that an entity has no current uncollateralized exposure to a

    counterparty following netting and the posting of collateral.

    \874\ See letters from SIFMA AMG II and Vanguard.

    ---------------------------------------------------------------------------

    Accordingly, the final rules incorporate a formula which, for

    purposes of the substantial position analysis, provides that the amount

    of net uncollateralized exposure that is attributable to a particular

    major category of swap or security-based swap would be allocated pro

    rata in a manner that compares the amount of the entity's out-of-the-

    money positions in that major category to its total out-of-the-money

    positions in all categories that are subject to the netting

    arrangements with that counterparty.\875\ This approach does not

    require that any collateral be specifically earmarked to particular

    swaps or security-based swaps, and can be followed so long as

    collateral is posted based on the net exposure associated with all

    instruments subject to the applicable netting agreements with that

    particular counterparty.\876\

    ---------------------------------------------------------------------------

    \875\ CFTC Regulation Sec. 1.3(jjj)(2)(iii)(A); Exchange Act

    rule 3a67-3(b)(4). Under this formula, for example, if an entity's

    exposure to a particular counterparty is $120 million after

    accounting for netting and the posting of collateral, and, subject

    to netting, the entity has $40 million in out-of-the-money positions

    in security-based credit derivatives, $90 million in out-of-the-

    money positions in other security-based swaps, and $120 million in

    out-of-the money positions in swaps and other instruments subject to

    the netting agreements, then $19.2 million in net uncollateralized

    exposure would be attributed to the ``security-based credit

    derivatives'' category (equal to $120 million [middot] ($40 million/

    ($40 million + $90 million + $120 million)), and $43.2 million in

    net uncollateralized exposure would be attributed to the ``other

    security-based swaps'' category (equal to $120 million [middot] ($90

    million/($40 million + $90 million + $120 million)).

    \876\ Although one commenter suggested that the analysis should

    further consider whether there are collateral posting requirements

    that are specific to a particular position, we believe that the test

    we are adopting is flexible enough to address that possibility. To

    the extent that the parties' collateral arrangements provide that

    collateral be earmarked to particular swap or security-based swap

    positions, an entity may calculate its potential future exposure

    with respect to that counterparty with regard to the applicable

    major category of swaps or security-based swaps, without accounting

    for netting across categories or instruments.

    ---------------------------------------------------------------------------

    iv. Application of Current Exposure Test to Cleared, Fully

    Collateralized or Net In-the-Money Positions

    Although certain commenters have requested that the current

    uncollateralized exposure test explicitly exclude swap or security-

    based swap positions that are cleared, fully collateralized or net in-

    the-money,\877\ the final rules do not provide such exclusions. As we

    recognized in the Proposing Release, centrally cleared swaps and

    security-based swaps are subject to mark-to-market margining that would

    largely eliminate the uncollateralized exposure associated with a

    position, effectively resulting in the cleared position being excluded

    from the analysis.\878\ Also, by definition, fully collateralized

    positions are not associated with current uncollateralized exposure,

    and thus would be excluded from the analysis. As such, we do not

    believe that it would be necessary to explicitly exclude such positions

    from the analysis.\879\

    ---------------------------------------------------------------------------

    \877\ See letters from ICI I, SIFMA AMG II and Vanguard.

    \878\ See Proposing Release, 75 FR at 80189 n.92.

    \879\ Moreover, to the extent that such positions are associated

    with uncollateralized amounts, such as those that arise from

    thresholds or minimum transfer amounts pursuant to the applicable

    credit support annex, then those amounts present counterparty risk

    that should be considered as part of the major participant analysis.

    ---------------------------------------------------------------------------

    Similarly, we do not believe that it is necessary for the rules to

    explicitly exclude net in-the-money swap or security-based swap

    positions. If an entity does not have any current uncollateralized

    exposure to a particular counterparty--after accounting for the

    entity's netting agreement with that counterparty and the posting of

    collateral--then the entity may disregard its positions with that

    counterparty for purposes of calculating current uncollateralized

    exposure. Otherwise, it is appropriate to consider the contribution of

    all swaps or security-based swaps to current uncollateralized exposure,

    as determined by the allocation methodology discussed above.\880\

    ---------------------------------------------------------------------------

    \880\ Under that allocation approach, if none of the entity's

    swap or security-based swap positions in a major category with that

    counterparty are out-of-the-money, then none of the current exposure

    resulting from the netting agreement would be attributed to that

    major category.

    ---------------------------------------------------------------------------

    c. Potential Future Exposure Analysis

    The ``substantial position'' analysis also will consider an

    entity's ``aggregate potential outward exposure,'' which would reflect

    the potential exposure of the entity's swap or security-based swap

    positions in the applicable ``major'' category of swap or security-

    based swaps, subject to certain adjustments.\881\ The final rules

    implementing this test in general follow the proposed approach, but

    have been revised to address commenter concerns.

    ---------------------------------------------------------------------------

    \881\ CFTC Regulation Sec. 1.3(jjj)(3); Exchange Act rule 3a67-

    3(c).

    ---------------------------------------------------------------------------

    i. Purpose Underlying the Potential Future Exposure Test

    As discussed in the proposal, a potential future exposure test

    addresses the fact that a sole focus on current uncollateralized

    exposure could fail to identify risky entities until some time after

    they begin to pose the level of risk that should subject them to

    regulation as major participants.\882\ A potential future exposure test

    would allow the substantial position analysis to account for this risk

    by addressing how the value of an entity's swap or security-based swap

    positions may move against the entity over time.\883\

    ---------------------------------------------------------------------------

    \882\ See Proposing Release, 75 FR at 80188.

    \883\ See id. at 80191.

    ---------------------------------------------------------------------------

    Accordingly, consistent with the proposal, the final rules

    incorporate a potential future exposure test that seeks to estimate how

    much the value of swaps or security-based swaps might change against an

    entity over the remaining life of the contract. Although some

    commenters took the view that this test should only address potential

    volatility during the period of time it would take for a non-defaulting

    party to close out positions and liquidate collateral,\884\ we believe

    that it is more appropriate for the analysis to consider the risks that

    swaps or security-based swap positions pose over the lives of those

    positions. An exclusive focus on short-term risks would fail to account

    for the possibility that an entity's large swap or security-based swap

    positions can readily produce large losses in adverse market

    circumstances, potentially leading either to large uncollateralized

    exposure (if the posting of collateral is not required), or to large

    collateral calls that may lead to the entity's default (or to calls for

    extraordinary action) and that can threaten non-defaulting parties with

    significant costs and challenges in connection with liquidating and

    replacing those positions. The analysis should give appropriate weight

    to those risks.

    ---------------------------------------------------------------------------

    \884\ See letters from SIFMA AMG II and Vanguard.

    ---------------------------------------------------------------------------

    ii. Risk Multipliers

    Subject to modifications addressed below, the final rules

    implementing the ``substantial position'' analysis incorporate a

    potential future exposure test based on the proposal's general approach

    of adjusting notional positions using risk multipliers.\885\ This

    approach incorporates and builds upon tests used by bank regulators for

    the purposes of setting prudential capital.\886\ Through

    [[Page 30669]]

    this methodology, the final rules implement an objective approach that

    readily can be replicated by market participants.

    ---------------------------------------------------------------------------

    \885\ See CFTC Regulation Sec. 1.3(jjj)(3)(ii)(A)(1); Exchange

    Act rule 3a67-3(c)(2)(i).

    \886\ See 12 CFR part 3, app. C, section 32 (Office of the

    Comptroller of the Currency capital adequacy guidelines for banks);

    12 CFR part 325, app. D, section 32 (Federal Deposit Insurance Corp.

    capital adequacy guidelines for banks); 12 CFR part 208, app. F,

    section 32 (Federal Reserve System capital adequacy guidelines for

    banks); 12 CFR part 225, app. G, section 32 (Federal Reserve System

    capital adequacy guidelines for bank holding companies).

    ---------------------------------------------------------------------------

    Although some commenters have suggested the use of value-at-risk

    measures or internal models to evaluate potential future exposure,\887\

    we do not believe that such approaches would be well tailored to be

    implemented by a range of market participants, or would lead to

    comparable results across market participants with identical swap or

    security-based swap portfolios.

    ---------------------------------------------------------------------------

    \887\ See letters from Riverside Risk Advisors and Better

    Markets I.

    ---------------------------------------------------------------------------

    In adopting this approach, we are mindful of the significance of

    commenter concerns about the adequacy of the tables that set forth the

    risk multipliers that would be applied to notional positions. These

    comments address, among other issues: discontinuities in the tables;

    the failure to account for whether, and how much, a swap or security-

    based swap is in-the-money or out-of-the money; the failure of the

    multipliers applicable to interest rate swaps to distinguish between

    counterparties who pay floating rates and counterparties who pay fixed

    rates; the failure of the multipliers in the credit category to account

    for the volatility of the underlying instrument or the duration of the

    swap or security-based swap; the failure of the multipliers for equity

    and commodity swaps to distinguish between high-volatility and low-

    volatility stocks and commodities; the adequacy of how the test

    addresses diversification and correlation; the fact that the approach

    does not provide for delta weighting of options positions; and the fact

    that the factors do not distinguish between index and single-name

    credit default swaps.\888\ While we acknowledge that it may be possible

    to develop revised risk multipliers that are more finely tuned to

    reflect relevant risk factors, at this time we believe that it would be

    most appropriate to implement the ``substantial position'' analysis by

    building upon an existing regulatory approach that is comparatively

    simpler to implement and leads to reproducible results, rather than

    seeking to develop a brand new approach.\889\

    ---------------------------------------------------------------------------

    \888\ See, e.g., letters from Riverside Risk Advisors and MFA I.

    \889\ We also are not following a commenter suggestion to

    incorporate the ``standardized method'' prescribed as part of the

    ``Basel II'' bank capital methodology. See letter from ISDA I. The

    standardized method relies on counterparty credit ratings provided

    by external credit rating agencies for purposes of calculating risk-

    weighted capital measurements. See ``International Convergence of

    Capital Measurement and Capital Standards, A Revised Framework,

    Comprehensive Version,'' the Basel Committee on Banking Supervision,

    June 2006. Incorporating this reliance on credit ratings provided by

    external credit rating agencies into these final rules would be

    inconsistent with Section 939A of the Dodd-Frank Act, which required

    all Federal agencies to review and modify existing regulations ``to

    remove any reference to or requirement of reliance on credit ratings

    and to substitute in such regulations such standard of credit-

    worthiness as each respective agency shall determine as appropriate

    for such regulations.''

    ---------------------------------------------------------------------------

    The final rules implementing the ``major security-based swap

    participant'' definition, however, modify the proposed risk multipliers

    in response to commenter concerns about how the ``major'' categories of

    security-based swaps should be applied to the risk multiplier

    categories. In particular, the final risk multiplier category for

    security-based swaps in the ``equity and other'' category encompasses

    all security-based swaps that are not credit derivatives, and the final

    rules eliminate the proposed category for ``other'' types of security-

    based swaps.\890\

    ---------------------------------------------------------------------------

    \890\ See Exchange Act rule 3a67-3(c)(2)(i). Aside from making

    the risk multipliers consistent with the ``major'' categories of

    security-based swaps, this change also should allow total return

    swaps on debt to be subject to the same risk multipliers as total

    return swaps on equity, rather than causing the debt swaps to be

    subject to higher multipliers (which may not accurately reflect the

    comparative risks of those instruments).

    ---------------------------------------------------------------------------

    iii. Potential Future Exposure Measures for Certain Lower-Risk

    Positions

    Consistent with the proposal, the potential future exposure

    calculation will exclude purchases of options and other positions for

    which a person has prepaid or otherwise satisfied its payment

    obligations.\891\ Also, in response to commenter concerns, the final

    rules expand on the proposal with regard to capping the potential

    future exposure associated with certain lower-risk swap and security-

    based swap positions. The final rules particularly cap--at the net

    present value of the unpaid premiums--the potential future exposure

    associated with positions by which a person buys credit protection

    using a credit default swap, and positions by which a person purchases

    an option for which the person retains additional payment obligations

    under the position.\892\ This reflects the reduced risk associated with

    such positions. The final rules do not prescribe a particular discount

    rate for purposes of this analysis, and market participants instead

    should use a commercially appropriate discount rate.

    ---------------------------------------------------------------------------

    \891\ See CFTC Regulation Sec. 1.3(jjj)(3)(ii)(A)(3)(ii);

    Exchange Act rule 3a67-3(c)(2)(i)(C).

    \892\ See CFTC Regulation Sec. 1.3(jjj)(3)(ii)(A)(4); Exchange

    Act rule 3a67-3(c)(2)(i)(D). The proposed rules would have applied

    this net present value caps only to the purchase of credit

    protection. The final rules expand this provision by also capping

    the potential future exposure associated with the purchases of

    options in which an entity retains payment obligations, to reflect

    the reduced risk associated with those positions.

    ---------------------------------------------------------------------------

    In addition, to better align the results of the potential future

    exposure analysis with the risks that a person presents, the final

    rules have been modified from the proposal to also exclude swap or

    security-based swap positions for which, pursuant to regulatory

    requirement, a person has placed in reserve an amount of cash or

    Treasury securities that is sufficient to pay the person's maximum

    possible liability under the position, when the person is prohibited

    from using that cash or those securities without also liquidating the

    swap or security-based swap position.\893\

    ---------------------------------------------------------------------------

    \893\ CFTC Regulation Sec. 1.3(jjj)(3)(ii)(A)(3)(iii); Exchange

    Act rule 3a67-3(c)(2)(i)(C)(3). This exclusion of such positions

    from the major participant analysis may apply, for example, to

    certain swap or security-based swap positions of insurers where

    applicable law requires an amount equal to the maximum possible

    exposure of the insurer be segregated.

    ---------------------------------------------------------------------------

    iv. Adjustments for Netting

    Consistent with the proposal, and with the bank regulator standards

    that form the basis for these potential future exposure measures, the

    final rules provide that an entity may reduce the measure of its

    potential future exposure in a major category by up to 60 percent to

    reflect the risk mitigation effects of master netting agreements. We

    believe that this approach appropriately reflects the risk mitigating

    attributes of netting on potential future exposure. Moreover, in light

    of commenter requests for clarification of how these netting provisions

    would be applied,\894\ the final rules have been revised from the

    proposal to provide that the risk reduction associated with netting

    should be estimated using the same pro rata allocation methodology that

    will be used to measure current exposure.\895\

    ---------------------------------------------------------------------------

    \894\ See letter from SIFMA AMG II.

    \895\ Consistent with the proposal, the effects of netting are

    to be estimated using the formula: P Net = 0.4 x P Gross + 0.6 x NGR

    x P Gross. Under that equation, P Net is the potential exposure

    adjusted for bilateral netting; P Gross is that potential outward

    exposure without adjustment for bilateral netting; and NGR is the

    net to gross ratio. The final rule has been revised from the

    proposal to clarify that the net to gross ratio equals the current

    exposure associated with the major category as calculated using the

    pro rata methodology discussed above, divided by what the measure of

    current exposure in connection with those out-of-the-money positions

    would be in the absence of that methodology.

    Accordingly, for the example set forth in note 875, supra, the

    NGR for ``security-based credit derivatives'' and ``other security-

    based swaps'' both would equal 0.48 (equal to $19.2 million net

    exposure divided by $40 million in out-of-the-money positions in the

    case of ``security-based credit derivatives,'' or $43.2 million net

    exposure divided by $90 million in out-of-the-money positions in the

    case of ``other security-based swaps''). If an entity has no current

    exposure to a counterparty following the application of netting

    arrangements and collateralization, the NGR for those positions

    would equal zero, and the potential exposure would equal 40 percent

    of what it would equal otherwise.

    ---------------------------------------------------------------------------

    [[Page 30670]]

    v. Adjustments for Cleared and Margined Positions

    The final rules also provide for the measure of potential future

    exposure to be adjusted in the case of swap and security-based swap

    positions that are centrally cleared or that are subject to daily mark-

    to-market margining. This is consistent with the purpose of the

    potential future exposure test, which is to account for the extent to

    which the current outward exposure of positions (though possibly low or

    even zero at the time of measurement) might grow to levels that can

    lead to high counterparty risk to counterparties or to the markets

    generally. The practice of the periodic exchange of mark-to-market

    margin between counterparties helps to mitigate the potential for large

    future increases in current exposure.

    Consistent with the proposal, the final rules reflect this ability

    to mitigate risk by providing that the potential future exposure

    associated with positions that are subject to daily mark-to-market

    margining will equal 0.2 times the amount that otherwise would be

    calculated. However, in response to commenters' opinions about the

    risk-mitigating effects of central clearing, and the additional level

    of rigor that clearing agencies may have with regards to the process

    and procedures for collecting daily margin, the final rules further

    provide that the potential future exposure associated with positions

    that are subject to central clearing will equal 0.1 (rather than the

    proposed 0.2) times the potential future exposure that would otherwise

    be calculated.\896\

    ---------------------------------------------------------------------------

    \896\ See CFTC Regulation Sec. 1.3(jjj)(3)(iii)(A); Exchange

    Act rule 3a67-3(c)(3)(i). The final rules further have been revised

    to clarify that the 0.1 factor applies to positions cleared by a

    registered clearing agency or by a clearing agency that has been

    exempted from registration.

    ---------------------------------------------------------------------------

    Although some commenters supported the complete exclusion of

    cleared positions from the potential future exposure analysis,\897\ and

    we are mindful of the risk mitigating attributes of central clearing,

    we also recognize that central clearing cannot reasonably be expected

    to entirely eliminate counterparty risk.\898\ We conclude, however,

    that the use of a 0.1 factor (in lieu of the proposed 0.2) would be

    appropriate for cleared positions, reflecting the strong risk

    mitigation features associated with central clearing, particularly the

    procedures regarding the collection of daily margin and the use of

    counterparty risk limits, while recognizing the presence of some

    remaining counterparty risk.

    ---------------------------------------------------------------------------

    \897\ See, e.g., letters from MFA I and SIFMA AMG II.

    \898\ Central clearing helps to mitigate counterparty credit

    risk by improving risk management and, among other things,

    mutualizing the risk of counterparty failure. If multiple members of

    a central counterparty fail beyond the level to which such risk is

    managed, however, the central counterparty would also be at risk of

    failure. Cf. Basel Committee on Banking Supervision, Consultative

    Document, ``Capitalisation of bank exposures to central

    counterparties,'' Nov. 25, 2011 (available at: http://www.bis.org/publ/bcbs206.pdf) (proposing that the capital charge for trade

    exposures to a qualifying central counterparty should carry a low

    risk weight, reflecting the relatively low risk of default of the

    qualifying central counterparty). In addition, as we discussed in

    the Proposing Release, see 75 FR at 80192 n.115, for example,

    central counterparties that clear credit default swaps do not

    necessarily become the counterparties of their members' customers

    (although even absent direct privity those central counterparties

    benefit customers by providing for protection of collateral they

    post as margin, and by providing procedures for the portability of

    customer positions in the event of a member's default). As a result,

    central clearing may not eliminate the counterparty risk that the

    customer poses to the member, although required mark-to-market

    margining should help control that risk, and central clearing would

    be expected to reduce the likelihood that an entity's default would

    lead to broader market impacts.

    ---------------------------------------------------------------------------

    Moreover, although some commenters opposed any deduction from the

    measure of potential future exposure for uncleared positions that are

    margined on a daily basis,\899\ we believe that the risk-mitigating

    attributes of daily margining warrant an adjustment given that the goal

    of the potential future exposure test is to account for price movements

    over the remaining life of the contract.\900\ The use of a 0.2 factor

    also reflects our expectation that the risk mitigation associated with

    uncleared but margined positions would be less than the risk mitigation

    associated with cleared positions.

    ---------------------------------------------------------------------------

    \899\ See letter from Better Markets I; see also letter from

    AFR.

    \900\ We do not believe that it is appropriate to have this type

    of discount when mark-to-market margining is done less than daily,

    however.

    ---------------------------------------------------------------------------

    While higher or lower alternatives to the 0.1 and 0.2 factors may

    also be reasonable for positions that are cleared or margined on a

    daily basis, we believe that the factors of the final rules reasonably

    reflects the risk mitigating (but not risk eliminating) features of

    those practices. The final rules also retain and clarify provisions

    addressing when daily mark-to-market margining occurs for purposes of

    this discount.\901\

    ---------------------------------------------------------------------------

    \901\ We recognize that at times, market participants whose

    agreements provide for the daily exchange of variation margin in

    connection with swaps or security-based swaps in practice may not

    exchange collateral daily, if the amounts at issue are relatively

    small (such as through the use of collateral thresholds and minimum

    transfer amounts). We do not believe that such practices would be

    inconsistent with providing a discount for daily margining

    practices. The proposed rules sought to accommodate those practices

    by providing that positions would be considered to be subject to

    daily mark-to-market margining for purposes of the

    ``uncollateralized outward exposure'' plus ``potential outward

    exposure'' analysis, so long as the total of such thresholds, and

    the total of such minimum transfer amounts above $1 million are

    deemed to be ``uncollateralized outward exposure'' for those

    purposes.

    In light of commenter concerns, which indicated that the

    proposal was not fully clear about the mechanics and purpose of this

    approach, the relevant rule language has been revised to clarify

    that this attribution of thresholds and minimum transfer amounts is

    solely for the purpose of determining whether certain positions are

    subject to daily mark-to-market margining for purposes of the

    analysis. In addition, the final rules have been revised from the

    proposal to provide that the attribution of thresholds as

    ``uncollateralized outward exposure'' for these purposes will be

    reduced by initial margin posted, up to the amount of the threshold.

    See CFTC Regulation Sec. 1.3(jjj)(iii)(B); Exchange Act rule 3a67-

    3(c)(3)(ii).

    ---------------------------------------------------------------------------

    vi. Application of ``Effective Notional'' Amounts

    Consistent with the proposal (as well as the rules implementing the

    de minimis exception to the dealer definitions), the potential future

    exposure test is based on the ``effective notional'' amount of the swap

    or security-based swap when the stated notional is leveraged or

    enhanced by the structure of the swap or security-based swap.\902\

    ---------------------------------------------------------------------------

    \902\ As discussed above, this may occur, for example, if the

    exchange of payments associated with an equity swap is based on a

    multiple of the return associated with the underlying equity. As is

    the case for measuring current exposure, the final rules do not

    prescribe any particular methodology for calculating the notional

    amount or effective notional amount used in the calculation of

    potential future exposure, but instead contemplate the use of

    industry standard practices.

    ---------------------------------------------------------------------------

    Moreover, as discussed in the Proposing Release,\903\ in the case

    of positions that represent the sale of an option on a swap or

    security-based swap (other than the sale of an option permitting the

    person exercising the option to purchase a credit default swap), we

    would view the effective notional amount of the option as being equal

    to the effective notional amount of the underlying swap or security-

    based swap, and in general we would view the duration used for purposes

    of the formula as being equal to the sum of the duration of the option

    and the duration of the underlying swap or security-based swap.\904\

    ---------------------------------------------------------------------------

    \903\ See Proposing Release, 75 FR 80192 n.110.

    \904\ The effective notional amount of the underlying instrument

    is used for these purposes because that amount fairly reflects the

    basis for measuring the potential counterparty risk associated with

    the instrument. The sum of the duration of the option and the

    underlying instrument is used for these purposes because that sum

    reflects the length of time of the potential counterparty risk

    associated with the instrument.

    At the same time, we agree with a commenter's view that if the

    underlying swap or security-based swap is cash settled, the

    calculation of duration will only include the duration of the

    option, and not the duration of the swap, because counterparty

    exposure would exist only until the option expiration date. See

    letter from MFA I.

    ---------------------------------------------------------------------------

    [[Page 30671]]

    vii. Treatment of Initial Margin or Overcollateralization

    The final rules retain the proposed approach of not modifying the

    measure of potential future exposure to reflect collateral that a

    person has posted to its counterparty in excess of current exposure.

    Although we recognize that the posting of excess collateral may

    mitigate the future credit risk that the potential future exposure

    measure is intended to estimate, that mitigating effect is not certain,

    and any such mitigation may not reflect the full value of the excess

    collateral. Moreover, while we believe that the measure of potential

    future exposure associated with swap or security-based swap positions

    reasonably estimates the credit risk that may be posed by those

    positions for purposes of the substantial position analysis, we also

    recognize that particular positions may prove to pose a far higher

    amount of credit risk.\905\ Given how the credit risk associated with a

    swap or security-based swap position can far exceed the associated

    measure of potential future exposure, we do not believe that it would

    be appropriate to offset that measure to account for

    overcollateralization.\906\

    ---------------------------------------------------------------------------

    \905\ For example, if a person writes a CDS that provides $10

    billion in protection on a reference entity, with the CDS being

    subject to daily mark-to-market margining, then for purposes of the

    substantial position analysis that CDS would be associated with a

    potential future exposure measure of no more than $200 million

    (reflecting the 0.1 conversion factor and the additional 0.2

    multiplier for margined positions), even before accounting for

    netting. Yet if the reference entity were to default, the writer of

    the CDS could pose up to $10 billion in credit risk to its

    counterparty.

    \906\ However, as discussed above, see note 901, supra, initial

    margin may be considered when determining if a collateral threshold

    is to be attributed to current uncollateralized exposure for

    purposes of determining whether certain positions are subject to

    daily mark-to-market margining for purposes of the substantial

    position analysis.

    ---------------------------------------------------------------------------

    d. Thresholds

    The final rules retain the proposed thresholds for the amount of

    current uncollateralized exposure and potential future exposure that

    will cause an entity to be deemed to be a major participant.

    Accordingly, for a person to have a ``substantial position'' in a major

    category of swaps, it would be necessary for that person to have a

    daily average current uncollateralized exposure of at least $1 billion

    (or $3 billion for the rate swap category), or a daily average current

    uncollateralized exposure plus potential future exposure of $2 billion

    (or $6 billion for the rate swap category).\907\ To have a

    ``substantial position'' in a major category of security-based swaps,

    it would be necessary for the person to have a daily average current

    uncollateralized exposure of at least $1 billion, or a daily average

    current uncollateralized exposure plus potential future exposure of at

    least $2 billion.\908\

    ---------------------------------------------------------------------------

    \907\ CFTC Regulation Sec. 1.3(jjj)(1).

    \908\ Exchange Act rule 3a67-3(a).

    ---------------------------------------------------------------------------

    As the Proposing Release noted, the proposed thresholds sought to

    reflect: (i) The financial system's ability to absorb losses of a

    particular size; (ii) the recognition that it would not be appropriate

    for the substantial position test to encompass entities only after they

    pose significant risks to the market through their swap or security-

    based swap activity; and (iii) the need to account for the possibility

    that multiple market participants may fail close in time.\909\ While

    some commenters took the position that the proposed thresholds were

    inappropriately low, those commenters did not present empirical data or

    analysis in support of that view. Moreover, the Commissions do not

    concur with the suggestion \910\ that the major participant definitions

    can reasonably be read to require that we defer this rulemaking until

    we have gathered additional data. Instead, the definitions direct us to

    set a standard that is ``prudent,'' which is what we have sought to do.

    ---------------------------------------------------------------------------

    \909\ As discussed above, we do not believe it would be prudent

    to presume that entity failures will be separated in time during

    periods of financial stress.

    \910\ See letters from BlackRock I and CCMR I.

    ---------------------------------------------------------------------------

    Some commenters who supported an increase in the proposed

    thresholds attempted to support their positions via analogy to past

    events, with the most significant of these being an analogy to AIG

    Financial Products (``AIG FP'').\911\ The analogy to AIG FP \912\

    actually argues against an increase in these thresholds, however,

    particularly given that the credit derivative portfolio that

    significantly contributed to the liquidity problems that AIG FP faced

    amounted to $72 billion in notional amount.\913\ Under the final rules,

    in the presence of central clearing or daily marking to market it would

    take a credit derivative portfolio in excess of that amount to trigger

    the potential future exposure threshold under the ``substantial

    position'' analysis.\914\ This indicates that the thresholds are not

    inappropriately low, particularly given our view that the major

    participant definition is intended to encompass entities before their

    swap or security-based swap positions pose significant market

    threats.\915\ Conversely, while

    [[Page 30672]]

    additional data and analysis may warrant a reduction of these

    thresholds in the future, commenters who supported a reduction in those

    thresholds have not persuaded us that the proposed thresholds should be

    lowered.

    ---------------------------------------------------------------------------

    \911\ See letter from ABC/CIEBA. One commenter's analogy to

    Enron also is unpersuasive. See letter from BG LNG I. In particular,

    the $18.7 billion in Enron derivatives exposure cited by that

    commenter does not account for collateral posted in connection with

    those positions. Also, the market impact of Enron's bankruptcy was

    substantially mitigated by the sale of Enron's derivatives trading

    arm to a third party.

    Moreover, although one commenter generally alluded to corporate

    financial losses in the derivatives markets that exceeded the

    proposed $1 billion and $2 billion thresholds, see letter from NCGA/

    NGSA II, the relevant question does not focus on losses that market

    participants have incurred, but instead focuses on what degree of

    credit risk to counterparties in the swap and security-based swap

    markets presents such a potential to cause significant market impact

    that it would be prudent to regulate persons who pose that degree of

    credit risk in connection with their swap or security-based swap

    positions.

    \912\ Our discussion of how the major participant analysis may

    apply to an entity that has a portfolio of a size equivalent to that

    of AIG FP should not be read to imply that a person may engage in

    swap and security-based swap activities akin to those of AIG FP

    without registering as a swap dealer or security-based swap dealer.

    \913\ See, e.g., Congressional Oversight Panel, The AIG Rescue,

    Its Impact on Markets, and the Government's Exit Strategy 22-24

    (2010) (discussing how the risk in AIG's CDS business largely was

    the result of a ``multi-sector'' CDO book that amounted to $72

    billion notional as of September 2008, and how the losses to AIG

    were driven by 125 of the roughly 44,000 contracts entered into by

    AIG FP).

    \914\ For cleared security-based credit default swaps (in which

    we assume daily margining requirements result in no current

    uncollateralized exposure) achieving $2 billion of potential future

    exposure would require writing $200 billion notional of credit

    default swap protection (reflecting the 0.10 multiplier in the risk

    adjustment tables, and the additional 0.10 multiplier for positions

    that are cleared). Similarly, it would take a $100 billion notional

    portfolio of uncleared but marked-to-market security-based credit

    default swaps to meet that same threshold (reflecting the 0.20

    multiplier for positions that are subject to daily mark-to-market

    margining). The total might be even higher if such instruments were

    subject to counterparty netting agreements.

    Even in the absence of clearing or daily mark-to-market

    margining, it would take a minimum $20 billion notional portfolio of

    written protection on credit (reflecting the 0.10 multiplier in the

    risk adjustment tables) to meet the $2 billion potential future

    exposure threshold. Accounting for netting (which can reduce

    potential future exposure measures by up to 60 percent) could

    materially increase that required amount.

    \915\ The case of Long-Term Capital Management (``LTCM'') also

    is instructive in connection with the current exposure thresholds of

    the major participant analysis. Had LTCM failed, its top 17

    counterparties would have suffered estimated total losses of between

    $3 and $5 billion. See President's Working Group on Financial

    Markets, Hedge Funds, Leverage, and the Lessons of Long-Term Capital

    Management (April 1999) at 17 (http://www.treasury.gov/resource-center/fin-mkts/Documents/hedgfund.pdf). The government acted in

    connection with LTCM because the rushed close-out of LTCM's

    positions would have affected other market participants, and the

    spread of losses would have led to market uncertainty, likely

    causing a number of credit and interest rate markets to experience

    extreme price moves and possibly not function for a period of time.

    See Statement by William J. McDonough, President Federal Reserve

    Bank of New York before the Committee on Banking and Financial

    Services U.S. House of Representatives (October 1, 1998) (http://www.newyorkfed.org/newsevents/speeches_archive/1998/mcd981001.html).

    ---------------------------------------------------------------------------

    e. Additional Issues

    The final rules applying the ``substantial position'' analysis and

    the major participant definitions generally apply to all types of swaps

    or security-based swaps that a person maintains. Although one commenter

    suggested that swaps on government securities should be excluded from

    the analysis, the rules will not provide such an exclusion. To the

    extent that a person presents credit risk as a result of swaps

    referencing government securities, there is no basis for disregarding

    that risk when determining whether the person is a major participant.

    In addition, in light of one commenter's concern,\916\ the

    Commissions believe that it is important to emphasize that these rules

    should not be interpreted to deter end-users from requesting margin

    from dealers or major participants who are their counterparties to

    swaps or security-based swaps.

    ---------------------------------------------------------------------------

    \916\ See letter from FHLB I.

    ---------------------------------------------------------------------------

    Also, in light of a point raised by another commenter,\917\ the

    Commissions note that these rules implementing the major participant

    definitions do not place any independent calculation or other

    obligations upon counterparties to potential major participants, and

    that the rules do not preclude a potential major participant from

    seeking the assistance of a third party to perform the relevant

    calculation.

    ---------------------------------------------------------------------------

    \917\ See letter from ISDA I.

    ---------------------------------------------------------------------------

    C. ``Hedging or Mitigating Commercial Risk''

    1. Proposed Approach

    a. General Availability of the Proposed Exclusion

    The first test of the major participant definitions excludes

    positions held for ``hedging or mitigating commercial risk'' from the

    substantial position analysis.\918\ In the Proposing Release, we

    preliminarily concluded that positions that hedge or mitigate a

    person's commercial risk may qualify for this exclusion regardless of

    whether the entity is financial or non-financial in nature.\919\ That

    conclusion in part was prompted by the fact that the statutory major

    participant definitions do not explicitly make the exclusion

    unavailable to financial entities; in contrast to the Title VII

    exceptions from mandatory clearing requirements in connection with

    hedging commercial risk,\920\ which explicitly are unavailable to

    financial entities.\921\ The conclusion also was prompted by the

    presence of the third major participant test--which specifically

    applies the substantial position analysis to certain non-bank financial

    entities but (unlike the first test) does not exclude commercial risk

    hedging positions from the analysis.\922\

    ---------------------------------------------------------------------------

    \918\ See CEA section 1a(33)(A)(i)(I); Exchange Act section

    3(a)(67)(A)(i)(I).

    \919\ See Proposing Release, 75 FR at 80194.

    \920\ See CEA section 2(h)(7)(A); Exchange Act section

    3C(g)(1)(B).

    \921\ As we discussed in the Proposing Release, had the Dodd-

    Frank Act intended the phrase ``hedge or mitigate commercial risk''

    to apply only to activities of, or positions held by, non-financial

    entities, it would not have been necessary for the mandatory

    clearing exceptions to include additional provisions generally

    restricting the availability of the exceptions to non-financial

    entities. See Proposing Release, 75 FR at 80194.

    \922\ As we discussed in the Proposing Release, the third

    statutory major participant test would be redundant if the hedging

    exclusion in the first major participant test were entirely

    unavailable to financial entities. See Proposing Release, 75 FR at

    80194 n.125.

    ---------------------------------------------------------------------------

    In the Proposing Release, we also preliminarily concluded that the

    question of whether an activity is commercial in nature should not be

    determined solely by a person's organizational status as a for-profit,

    non-profit or governmental entity, but instead should depend on whether

    the underlying activity is commercial in nature.\923\

    ---------------------------------------------------------------------------

    \923\ See Proposing Release, 75 FR at 80194.

    ---------------------------------------------------------------------------

    The proposal did not preclude the exclusion from being available in

    connection with hedges of a person's ``financial'' or ``balance sheet''

    risks. In addition, the proposal solicited comment as to whether the

    exclusion should extend to activities in which a person hedges an

    affiliate's risk.

    b. Proposed Definition Under the CEA Exception

    The proposed interpretation of ``hedging or mitigating commercial

    risk'' for purposes of the CEA's definition of ``major swap

    participant'' premised the exclusion on the principle that swaps

    necessary to the conduct or management of a person's commercial

    activities should not be included in the calculation of the entity's

    substantial position.\924\

    ---------------------------------------------------------------------------

    \924\ The scope of the proposed exclusion is based on our

    understanding that when a swap or security-based swap is used to

    hedge a person's commercial activities, the gains or losses

    associated with the swap or security-based swap itself will

    generally be offset by losses or gains in the person's commercial

    activities, and hence the risks posed by the swap or security-based

    swap to counterparties or the industry will generally be mitigated.

    ---------------------------------------------------------------------------

    The CFTC noted first that the phrase ``hedging or mitigating

    commercial risk'' as used with respect to the major swap participant

    definition is virtually identical to Dodd-Frank provisions granting an

    exception from the mandatory clearing requirement to non-financial

    entities that are using swaps to hedge or mitigate commercial

    risk.\925\ Also noted was that although only non-financial entities

    that use swaps or security-based swaps to hedge or mitigate commercial

    risk generally may qualify for the clearing exemption, no such

    statutory restriction applies with respect to the exclusion for hedging

    positions in the first test of a major participant. We therefore

    concluded that positions established to hedge or mitigate commercial

    risk may qualify for the exclusion, regardless of the nature of the

    entity--i.e., whether or not the entity is financial (including a bank)

    or non-financial.\926\

    ---------------------------------------------------------------------------

    \925\ See CEA section 2(h)(7)(A); Exchange Act section

    3C(g)(1)(B) (exception from mandatory clearing requirements when one

    or more counterparties are not ``financial entities'' and are using

    swaps or security-based swaps to ``hedge or mitigate commercial

    risk'').

    \926\ The presence of the third major participant test suggests

    that financial entities generally may not be precluded from taking

    advantage of the hedging exclusion in the first test. The third

    test, which does not account for hedging, specifically applies to

    non-bank financial entities that are highly leveraged and have a

    substantial position in a major category of swaps or security-based

    swaps. That test would be redundant if the hedging exclusion in the

    first major participant test were entirely unavailable to financial

    entities.

    ---------------------------------------------------------------------------

    The CFTC preliminarily believed that whether a position hedges or

    mitigates commercial risk should be determined by the facts and

    circumstances at the time the swap is entered into, and should take

    into account the entity's overall hedging and risk mitigation

    strategies. However, the swap could not be held for a purpose that is

    in the nature of speculation, investing or trading. We anticipated that

    a person's overall hedging and risk management strategies would help

    inform whether or not a particular position is properly considered to

    hedge or mitigate commercial risk. Further, the exclusion under the

    Proposing Release included swaps hedging or mitigating any of a

    person's business risks, regardless of the

    [[Page 30673]]

    swap's status under accounting guidelines or the bona fide hedging

    exemption.

    c. Proposed Definition Under the Exchange Act Exception

    For purposes of the Exchange Act's ``major security-based swap

    participant'' definition, the proposed rule defining ``hedging or

    mitigating commercial risk'' would require that a security-based swap

    position be ``economically appropriate'' to the reduction of risks in

    the conduct and management of a commercial enterprise, where those

    risks arise from the potential change in the value of assets,

    liabilities and services connected with the ordinary course of business

    of the enterprise.\927\ The Proposing Release stated that the SEC

    preliminarily planned to interpret the concept of ``economically

    appropriate'' based on whether a reasonably prudent person would

    consider the security-based swap to be appropriate for managing the

    identified commercial risk. It further stated that the SEC also

    preliminarily believed that for a security-based swap to be deemed

    ``economically appropriate'' in this context, it should not introduce

    any new material quantum of risks (i.e., it could not reflect over-

    hedging that could reasonably have a speculative effect) and it should

    not introduce any basis risk or other new types of risk (other than the

    counterparty risk that is attendant to all security-based swaps) more

    than reasonably necessary to manage the identified risk.\928\

    ---------------------------------------------------------------------------

    \927\ See proposed Exchange Act rule 3a67-4(a).

    \928\ See Proposing Release, 75 FR at 80195 n.129.

    ---------------------------------------------------------------------------

    The proposed rules further provided that the security-based swap

    position could not be held for a purpose that is in the nature of

    speculation or trading--a limitation that would make the exclusion

    unavailable to security-based swap positions that are held

    intentionally for the short term and/or with the intent of benefiting

    from actual or expected short-term price movements or to lock in

    arbitrage profits, including security-based swap positions that hedge

    other positions that themselves are held for the purpose of speculation

    or trading.\929\ The proposal also provided that a security-based swap

    position could not be held to hedge or mitigate the risk of another

    security-based swap position or swap position unless that other

    position itself is held for the purpose of hedging or mitigating

    commercial risk.\930\ Finally, the proposal would have conditioned the

    entity's ability to exclude these security-based swap positions on the

    entity engaging in certain specified activities related to documenting

    the underlying risks and assessing the effectiveness of the hedge in

    connection with the security-based swap positions.\931\

    ---------------------------------------------------------------------------

    \929\ See proposed Exchange Act rule 3a67-4(b)(1), and Proposing

    Release, 75 FR at 80195 n.131.

    \930\ See proposed Exchange Act rule 3a67-4(b)(2).

    \931\ See proposed Exchange Act rule 3a67-4(c).

    ---------------------------------------------------------------------------

    2. Commenters' Views

    a. In General

    Several commenters generally supported the broad concepts

    underlying the proposed rules for identifying hedges of commercial

    risk, and particularly supported the proposed use of an ``economically

    appropriate'' standard instead of the ``highly effective'' standard

    that is used to identify hedges for accounting purposes.\932\ On the

    other hand, one commenter stated that the definition should incorporate

    all manner of risks associated with commercial operations, including

    interest rate and currency risks, risks from incidental activities to

    commercial activities and risks from financial commodities.\933\ One

    commenter further stated that the definition should encompass positions

    that facilitate asset optimization and dynamic hedging.\934\

    ---------------------------------------------------------------------------

    \932\ See letters from ACLI, Barnard, CDEU, COPE I, EEI/EPSA,

    FSR I, ISDA I, Kraft, MetLife, NAIC, Philip Morris International

    Inc. (``Philip Morris'') and Utility Group.

    \933\ See letter from CDEU.

    \934\ See letter from Peabody.

    ---------------------------------------------------------------------------

    Commenters further stated that the exception should include any

    position taken as part of a bona fide risk mitigation strategy,\935\

    and that Congress included ``mitigation'' in the exception for the

    purpose of covering risk reduction strategies that may not clearly be

    hedges but mitigate risk.\936\ Some commenters also criticized the

    Proposing Release's position equating the terms ``hedging'' and

    ``mitigating.'' \937\ One commenter also expressed concern that

    entities would find it difficult to analyze their positions with

    respect to the Proposing Release's statement, in the context of the

    Exchange Act definition, that ``economically appropriate'' security-

    based swaps would not add a new quantum of risk.\938\

    ---------------------------------------------------------------------------

    \935\ See letter from ISDA I.

    \936\ See letter from CDEU.

    \937\ See letters from APG, CDEU and ISDA I.

    \938\ See letter from SIFMA AMG II.

    ---------------------------------------------------------------------------

    Conversely, some commenters suggested that the proposed

    interpretation was too broad,\939\ and that a broad interpretation

    could allow evasion,\940\ or permit corporate end users to accumulate

    very large positions without becoming major swap participants.\941\ One

    commenter stated that to include ``financial risks'' within the

    exclusion's scope would be improper because a ``commercial risk'' is

    one that is inherent in a person's commercial activities, while

    interest rate and currency risks arise from choices about how a person

    structures and finances its operations.\942\ Some commenters stated

    that the rule should not include hedging of financial risks because

    Congress deleted the reference in an earlier version of the Dodd-Frank

    Act to hedging of ``balance sheet risk.'' \943\ One commenter urged

    that we consider using accounting hedge treatment or the bona fide

    hedging exemption as guideposts for determining the availability of the

    exclusion.\944\ Commenters also raised concerns about differences

    between the proposed approaches under the CEA and Exchange Act

    definitions of the terms.\945\

    ---------------------------------------------------------------------------

    \939\ See letters from AFR and AFSCME. The CFTC also received

    submissions of a substantially identical letter from approximately

    193 individuals and small businesses urging the CFTC to define

    commercial risk narrowly to include only risks arising from physical

    commodity price fluctuations, and not financial risks, and to

    construe the exception for captive finance companies narrowly. See,

    e.g., letter from Needham Oil & Air, LLC. In addition, the CFTC

    received submissions from approximately 535 individuals of a

    different letter, which also urged the CFTC to define commercial

    risk narrowly. See, e.g., letter from Christie Hakim.

    \940\ See letters from Sen. Carl Levin (``Senator Levin''),

    Commodity Markets Oversight Coalition (``CMOC'') and Greenberger and

    meeting with MFA on February 14, 2011.

    \941\ See meeting with SIFMA AMG on February 4, 2011.

    \942\ See meeting with AFR and Better Markets on March 17, 2011.

    \943\ See letters from AFR and CMOC, and meeting with Duffie on

    February 2, 2011.

    \944\ See letter from Senator Levin.

    \945\ See letters from Senator Levin, NAIC and SIFMA AMG II.

    ---------------------------------------------------------------------------

    One commenter suggested that the definition should be expanded to

    include as commercial risks the risks faced by government entities

    because their need to manage risk is no different than the need of

    commercial firms.\946\ Additional commenters suggested that commercial

    risk be interpreted to include risks faced by non-profit firms.\947\

    ---------------------------------------------------------------------------

    \946\ See letter from Milbank, Tweed, Hadley & McCloy LLP

    (``Milbank'').

    \947\ See letters from CDEU and NFPEEU.

    ---------------------------------------------------------------------------

    Some commenters also supported modification of the rule text for

    specific purposes such as including risks from ``transmitting'' to

    cover activities of electricity companies,\948\ to encompass risks

    ``arising from'' an asset rather than just risks arising from changes

    in value

    [[Page 30674]]

    of the asset,\949\ and to encompass the use of swaps by structured

    finance special purpose vehicles to hedge interest rate risk in

    structured financing.\950\

    ---------------------------------------------------------------------------

    \948\ See letter from Edison Int'l.

    \949\ See letter from Milbank.

    \950\ See letter from American Securitization Forum (``ASR'').

    ---------------------------------------------------------------------------

    b. Availability of Exclusion to Financial Entities

    Several commenters supported making the exclusion available to

    financial companies.\951\ Some commenters further stated that there

    should be no special limits on financial entities with regard to the

    exclusion,\952\ and that commercial risk should be defined broadly to

    include all of the commercial activities of a person, whether or not

    those activities relate to financial or non-financial commodities.\953\

    Two commenters discussing the use of swaps by insurance companies

    stated that making the exclusion available to financial companies is

    consistent with CFTC practice in the futures markets, that there is no

    fundamental difference in how an insurance company or a commercial

    enterprise uses swaps to reduce its risk, and that commercial risk

    encompasses financial risk.\954\ In addition, these commenters noted

    that insurance regulators allow insurance companies to use swaps to

    hedge risk.\955\

    ---------------------------------------------------------------------------

    \951\ See letters from ACLI, American Express Company

    (``Amex''), California State Teachers' Retirement System

    (``CalSTRS'') dated Feb. 28, 2011 (``CalSTRS I''), ISDA I, MetLife,

    NAIC and Peabody.

    \952\ See letters from Amex, CalSTRS I and Peabody.

    \953\ See letter from Amex.

    \954\ See letters from ACLI and MetLife.

    \955\ Id.

    ---------------------------------------------------------------------------

    On the other hand, some commenters opposed allowing financial

    entities to avail themselves of the exclusion, arguing that there is no

    benefit from allowing a financial firm to avoid major participant

    regulation through the hedging exclusion,\956\ that the exclusion would

    allow financial companies to engage in risky trades,\957\ and that the

    exclusion should be narrowly interpreted to cover hedging of only risks

    related to products.\958\

    ---------------------------------------------------------------------------

    \956\ See letter from Senator Levin (further highlighting the

    need to add strict standards and controls to prevent evasion).

    \957\ See letters cited in note 939, supra.

    \958\ See letter from AFR.

    ---------------------------------------------------------------------------

    c. Hedging Risks of Affiliates and Third Parties

    Some commenters expressed support for allowing persons to take

    advantage of the hedging exclusion when they use swaps to hedge the

    commercial risks of affiliates or third parties. Some commenters

    suggested that a person that aggregates and hedges risk within a

    corporate group should be allowed to use the exclusion despite the fact

    that it is the affiliates' risks that are hedged.\959\ One commenter

    further stated that providers of risk management services should be

    allowed to take advantage of the exclusion because they are hedging

    commercial risk on behalf of their clients.\960\

    ---------------------------------------------------------------------------

    \959\ See letters from CDEU, EDF Trading, Kraft, Metlife and

    Philip Morris.

    \960\ See letter from EDF Trading.

    ---------------------------------------------------------------------------

    One commenter, on the other hand, stated that the exclusion should

    be read narrowly for captive finance companies because the hedging

    entity may have to liquidate positions rapidly without access to

    affiliate's funds.\961\

    ---------------------------------------------------------------------------

    \961\ See meeting with Duffie on February 2, 2011.

    ---------------------------------------------------------------------------

    d. Hedge Effectiveness and Documentation

    Many commenters suggested that the rule should not test hedge

    effectiveness, explaining that requiring demonstration of hedge

    effectiveness would impose a subjective standard and would not reduce

    systemic risk.\962\ In this regard, some commenters that addressed the

    proposed procedural requirements in the Exchange Act definition argued

    that these procedures would place unnecessary regulatory burdens on

    entities not regulated under the Dodd-Frank Act.\963\ Conversely, one

    commenter that supported testing hedge effectiveness stated that the

    subdivided parts of a hedge should line up exactly with the subdivided

    parts of the risk.\964\

    ---------------------------------------------------------------------------

    \962\ See letters from EEI/EPSA and EDF Trading; see also

    letters from CDEU, Kraft Metlife, NRG Energy and Philip Morris (that

    such a test would be overly prescriptive).

    \963\ See letters from FSR I and SIFMA AMG I.

    \964\ See letter from Better Markets I.

    ---------------------------------------------------------------------------

    Some commenters agreed that the relationship between hedging and

    risk should be documented. One commenter expressed the view that

    documentation would facilitate audits.\965\ Others took the view that a

    person should be required to demonstrate that the hedge does not create

    additional risk, that the risk may be hedged by swaps, and that there

    is a link between the swap and the risk.\966\

    ---------------------------------------------------------------------------

    \965\ See letter from Metlife (but opposing ongoing evaluation

    of hedge effectiveness).

    \966\ See letters from AFR and Senator Levin.

    ---------------------------------------------------------------------------

    Several commenters suggested that once initiated, a hedge should

    not be retested over time, regardless of whether the position continues

    to serve a hedging purpose.\967\ Other commenters disagreed, stating

    that a position that is no longer a hedge should not be covered by the

    exclusion.\968\

    ---------------------------------------------------------------------------

    \967\ See letters from CDEU, EDF Trading, EEI/EPSA, Kraft,

    Metlife, NRG Energy and Philip Morris.

    \968\ See letters from Better Markets I and Senator Levin.

    ---------------------------------------------------------------------------

    e. Swaps That Hedge Positions Held for Speculative, Investment or

    Trading Purposes

    Many commenters took the view that swaps or security-based swaps

    used to hedge positions held for speculative, investment or trading

    purposes should qualify as hedges of commercial risk.\969\ A few

    commenters stated that speculation, investment and trading are

    fundamental to commercial activity, and thus cannot be differentiated

    from other types of commercial activity.\970\ Other commenters

    suggested the exclusion should cover swap positions that hedge other

    swap or security-based swap positions that are not themselves hedging

    positions.\971\ Some commenters asserted that trading is different from

    speculating (taking an outright view on market direction) and investing

    (entering into a swap for appreciation in value of the swap position),

    and that swaps held for ``trading'' should be able to qualify for the

    exclusion.\972\

    ---------------------------------------------------------------------------

    \969\ See letters from BG LNG II, COPE I, EPSA, FSR I, Metlife,

    Peabody, Vitol and WGCEF dated February 22, 2011 regarding the major

    swap participant definition (``WGECF II''), and meeting with Bunge;

    see also letter from ISDA I (taking the view that swaps and

    security-based swaps used to hedge speculative positions should

    qualify as hedges and stating that failure to treat them as hedges

    would ``invariably result in there being more unhedged speculative

    risk in the market'').

    \970\ See letters from Vitol and WGCEF II and meeting with

    Bunge.

    \971\ See letters from BG LNG II, FSR I, ISDA I and Metlife.

    \972\ See letters from COPE I, EPSA and Peabody.

    ---------------------------------------------------------------------------

    Some commenters requested that the definition under the CEA clarify

    how swaps that qualify as bona fide hedges are treated for the major

    swap participant definition if the underlying position had a

    speculative, investment or trading purpose,\973\ and clarify that while

    the hedging exclusion would not apply to swap positions that hedge

    other swap positions that are held for speculation or trading, the

    hedging provision would apply to swap positions that hedge other non-

    swap positions held for speculation or trading.\974\ Commenters also

    requested that the final rules provide that the hedging exclusion be

    available for physical positions in exempt or agricultural commodities

    and arbitrage positions relating to price differences between physical

    commodities at

    [[Page 30675]]

    different locations.\975\ One commenter, on the other hand, suggested

    that even swap positions that hedge other swap positions which are not

    hedging positions should be treated as hedging commercial risk because

    they are risk reducing.\976\

    ---------------------------------------------------------------------------

    \973\ See letters from Vitol and WGCEF dated June 3, 2011

    regarding the major swap participant definition (``WGECF VI'').

    \974\ See letter from BG LNG II.

    \975\ See letters from BGLNG II and WGCEF VI.

    \976\ See letters from MetLife.

    ---------------------------------------------------------------------------

    Four commenters took the position that swaps held for a purpose

    that is in the nature of speculation, investing or trading should not

    qualify as hedges of commercial risk.\977\ One commenter pointed out

    that experience has shown that market participants sometimes

    inaccurately characterize positions as hedges (e.g., the inaccurate

    characterization occurs because the nature of positions change over

    time), and that excluding swap positions that hedge speculative,

    investment or trading positions would be especially inappropriate for

    financial firms that frequently use swaps to speculate, invest or

    trade.\978\ One commenter stated that any swap position hedging another

    swap position could never be considered to be hedging commercial risk

    because the second swap is only adjusting the first swap position,

    meaning that neither swap would be congruent with risk reduction.\979\

    Another commenter stated that the hedging exclusion should not cover

    any swap hedging a speculative position.\980\

    ---------------------------------------------------------------------------

    \977\ See letters from AFR, Better Markets I and Senator Levin

    and meeting with Duffie on February 2, 2011.

    \978\ See letter from Senator Levin.

    \979\ See letter from Better Markets I.

    \980\ See meeting with Duffie on February 2, 2011.

    ---------------------------------------------------------------------------

    3. Final Rules--General Availability of the Exclusions

    As with the proposed rules, the final CEA and Exchange Act rules

    implementing this exclusion are different in certain regards to reflect

    the different ways that swaps and security-based swaps may be expected

    to be used to hedge commercial risk, as well as differences in existing

    regulations under the CEA and the Exchange Act. Notwithstanding these

    differences, the two rules follow parallel approaches and address

    certain key issues in similar ways.

    a. Availability to Financial Entities

    Consistent with the position we took in the Proposing Release, the

    final rules with regard to both major participant definitions do not

    foreclose financial entities from being able to take advantage of the

    commercial risk hedging exclusion in the first major participant test.

    This conclusion in part is guided by the fact that the statutory text

    implementing this hedging exclusion does not explicitly foreclose

    financial entities from taking advantage of the exclusion--in contrast

    to Title VII's exceptions from mandatory clearing requirements for

    commercial risk hedging activities. The conclusion also results from

    the need to avoid an interpretation that would cause the third major

    participant test to be redundant.\981\

    ---------------------------------------------------------------------------

    \981\ While we recognize that commenters have identified policy

    reasons as to why financial entities should be entirely excluded

    from being able to take advantage of the hedging exclusion, we

    continue to believe the language of the major participant

    definitions dictates a contrary approach.

    ---------------------------------------------------------------------------

    In reaching this conclusion, we recognize that some commenters

    stated that there would be no benefit from allowing financial firms to

    avoid regulation as a major swap participant through the hedging

    exclusion, and that the exclusion should cover only risks related to

    non-financial commercial activities, or else the exclusion would allow

    financial companies to engage in risky transactions.\982\ We believe

    that not allowing the exclusion to cover swaps or security-based swaps

    used for speculation or trading (or investments, in the case of swaps)

    will be sufficient to limit financial entities' ability to engage in

    risky transactions. We also are not persuaded that ``commercial risk''

    should be limited to only risks related to non-financial activities.

    ---------------------------------------------------------------------------

    \982\ See letters from AFR and Senator Levin.

    ---------------------------------------------------------------------------

    We nonetheless recognize the significance of concerns that

    financial entities may seek to depict speculative positions as hedges

    to take advantage of the exclusion. We also are mindful of the need to

    give appropriate meaning to the term ``commercial risk'' within the

    exclusion. We believe that the standard set forth in the final rules,

    including the provisions that make the exclusions unavailable to swap

    or security-based swap positions of a speculative or trading nature (or

    investment purposes, in the case of swaps), apply the statutory test in

    a manner that appropriately addresses those other concerns. As

    discussed below, those standards limit the ability of financial

    entities to take advantage of the exclusion.\983\

    ---------------------------------------------------------------------------

    \983\ We also do not believe that the size of an entity or an

    entity's position is determinative of whether a position hedges

    commercial risk. Moreover, given that the major participant

    definitions implicitly require large swap or security-based swap

    positions as triggers, a rule that made the hedging exclusion

    unavailable to entities with large positions could negate the

    statutory hedging exclusion.

    ---------------------------------------------------------------------------

    b. Availability to Non-Profit and Governmental Entities

    Under the final rules, a person's organizational status will not

    determine the availability of this hedging exclusion. The exclusion

    thus may be available to non-profit or governmental entities, as well

    as to for-profit entities, if the underlying activity to which the swap

    or security-based swap relates is commercial in nature.

    c. Hedges of ``Financial'' or ``Balance Sheet'' Risks

    Under the final rules, the exclusion is available to positions that

    hedge ``financial'' or ``balance sheet'' risks. While we recognize that

    some commenters oppose the exclusion of those positions,\984\ we

    nonetheless believe that the exclusion would be impermissibly narrow if

    it failed to extend to the ``financial'' or ``balance sheet'' risks

    that entities may face as part of their commercial operations, given

    that those types of risks (e.g., interest rate and foreign exchange

    risks) may be expected to arise from the commercial operations of non-

    financial end-users of swaps and security-based swaps. We do not

    believe the exclusion was intended to address those risks differently

    from other commercial risks, such as risks associated with the cost of

    physical inputs or the price received for selling products.\985\

    ---------------------------------------------------------------------------

    \984\ See notes 942 and 943, supra.

    \985\ Moreover, it is questionable as to what types of security-

    based swap positions--if any--would fall within the exclusion for

    purposes of the ``major security-based swap participant'' definition

    if the exclusion did not extend to hedges of ``financial'' or

    ``balance sheet'' risks. Security-based swaps such as single-name

    credit default swaps and equity swaps would not appear amenable to

    hedging a commercial entity's non-financial risks, such as price

    risks associated with non-financial inputs or sales. We do not

    believe that it would be appropriate to interpret the exclusion in

    such a way as to make it a nullity in the context of the ``major

    security-based swap participant'' definition.

    ---------------------------------------------------------------------------

    d. Hedging on Behalf of an Affiliate

    The final rules further provide that the exclusion is not limited

    to the hedging of a person's own risks, but also would extend to the

    hedging of the risks of a person's majority-owned affiliate.\986\

    [[Page 30676]]

    This approach reflects the fact that a corporate group may use a single

    entity to face the market to engage in hedging activities on behalf of

    entities within the group. In our view, it would not be appropriate for

    the swap or security-based swap positions of the market-facing entity

    to be encompassed within the first major participant test if those same

    positions could have been excluded from the analysis if entered into

    directly by the affiliate.\987\ Of course, the exclusion will only be

    available to the market-facing entity if the position would have been

    subject to the exclusion--e.g., not for a speculative or trading

    purpose--had the affiliate directly entered into the position.

    ---------------------------------------------------------------------------

    \986\ See CFTC Regulation Sec. 1.3(kkk)(1)(i); Exchange Act

    rule 3a67-4(a)(1). For these purposes--consistent with the standards

    regarding the application of the dealer and major participant

    definitions to inter-affiliate swaps and security based swaps, see

    parts II.C and IV.G--we would view the counterparties to be

    majority-owned affiliates if one party directly or indirectly holds

    a majority ownership interest in the other, or if a third party

    directly or indirectly holds a majority interest in both, based on

    holding a majority of the equity securities of an entity, or the

    right to receive upon dissolution or the contribution of a majority

    of the capital of a partnership. See note 348, supra.

    \987\ The exclusion, however, would not be available to the

    extent that a person enters into swaps or security-based swaps in

    connection with the hedging activities of an unaffiliated third

    party. Such activities, moreover, may indicate that the person is

    acting as a swap dealer or security-based swap dealer.

    ---------------------------------------------------------------------------

    4. Final Rules--``Major Swap Participant'' Definition Under the CEA

    a. In General

    The general scope of the rule regarding ``hedging or mitigating

    risk'' will be adopted substantially as proposed.\988\ The CFTC,

    however, is adopting CFTC Regulation Sec. 1.3(kkk) with a modification

    to paragraph (1)(iii) to include a reference to qualified hedging

    treatment for positions meeting Government Accounting Standards Board

    (``GASB'') Statement 53, Accounting and Financial Reporting for

    Derivative Instruments. The CFTC believes that this minor modification

    to CFTC Regulation Sec. 1.3(kkk) is necessary in order to include

    swaps that qualify for hedging treatment issued by GASB.\989\

    ---------------------------------------------------------------------------

    \988\ The final rule text of CFTC Regulation Sec. 1.3(kkk)(2)

    has been revised to include the conjunction ``and'' between clauses

    (i) and (ii). In the proposed text of this rule, there was no

    conjunction between these two clauses, while the conjunction ``and''

    was used in the parallel rule, Sec. 240.3a67-4(b), under the

    Exchange Act. Thus, the revision of the final rule text conforms the

    CEA rule to the Exchange Act rule.

    Also, the final rule text of CFTC Regulation Sec.

    1.3(kkk)(1)(E) has been revised to include interest and currency

    rates to be consistent with Sec. 1.3(kkk)(1)(F). Both provisions

    address similar financial risks arising from rate ``movements'' and

    ``exposures,'' respectively.

    \989\ Local government entities that use GASB accounting

    standards may not be able to use comparable FASB hedge accounting as

    a demonstration that a swap is a hedge. Although the two standards

    are not the same, they are similar in effect and degree in respect

    of determining whether a swap hedges a risk.

    ---------------------------------------------------------------------------

    As noted above, the CFTC will not prohibit financial companies from

    using the hedging exclusion because the exclusion for positions held

    for hedging or mitigating commercial risk set forth in CEA section

    1a(33)(A)(i)(1) does not limit its application based on the

    characterization or status of the person or entity. Unlike the end-user

    clearing exemption of section 2(h)(7), the major swap participant

    hedging exclusion is not foreclosed to financial entities.\990\ In

    addition, the hedging exclusion will extend to entities hedging the

    risks of affiliates in a corporate group, but not to third parties

    outside of a corporate group.

    ---------------------------------------------------------------------------

    \990\ Although CEA section 1a(33)(A)(iii), 7 U.S.C.

    1a(33)(A)(iii) provides that financial entities that are highly

    leveraged and not subject to capital requirements established by a

    Federal banking agency are effectively precluded from applying the

    hedging exclusion, other financial entities are not so precluded.

    Thus, availability of the hedging exclusion to some financial

    entities for purposes of the major swap participant definition is

    contemplated in the statutory text.

    ---------------------------------------------------------------------------

    Like the proposed rule, the final rule under the CEA does not

    require a demonstration of hedge effectiveness, periodic retesting or

    specific documentation in order to apply the hedging exclusion from the

    definition of major swap participant.

    b. Swaps That Hedge Positions Held for Speculation, Investment, or

    Trading

    Swaps that hedge positions held for speculation, investment or

    trading will not qualify for the exclusion. In the Proposing Release,

    the CFTC explained that swap positions held for the purpose of

    speculation, investment or trading are those held primarily to take an

    outright view on market direction, including positions held for short

    term resale, or to obtain arbitrage profits.\991\ Additionally, the

    Proposing Release stated that swap positions that hedge other positions

    that themselves are held for the purpose of speculation, investment or

    trading are also speculative, investment or trading positions.\992\

    ---------------------------------------------------------------------------

    \991\ See 75 FR at 80195 n.128.

    \992\ Id.

    ---------------------------------------------------------------------------

    We note that some commenters suggested that swaps that hedge

    speculative, investment or trading positions should qualify for the

    exclusion because speculation, investment or trading are fundamental to

    commercial activity and cannot be differentiated from other types of

    commercial activity. Similarly, commenters that support allowing

    speculative, investment or trading positions to qualify for the

    exception stated that a swap hedging the risk of another swap

    (regardless of that swap's nature) is risk reducing and therefore

    hedges commercial risk. We believe that these commenters'

    interpretation of ``commercial'' is not consistent with congressional

    intent or the meaning of ``commercial'' in the Dodd-Frank Act with

    respect to the first test of the major participant definition or the

    end-user exception to the clearing mandate. We are unconvinced that

    allowing swap positions to qualify for the exception would be

    appropriate when used to hedge speculative, investment or trading

    positions because the swap would not hedge or mitigate the risks

    associated with the underlying position, or at least not in the manner

    intended by Congress. In addition, we believe that doing so would

    undermine the effectiveness of the major participant definition in that

    entities would be able to characterize positions for speculative,

    investment or trading purposes as hedges and therefore evade regulation

    as major participants.

    Under CFTC Regulation Sec. 1.3(kkk)(2)(i), swap positions executed

    for the purpose of speculating, investing, or trading are those

    positions executed primarily to take an outright view on market

    direction or to obtain an appreciation in value of the swap position

    itself, and not primarily for hedging or mitigating underlying

    commercial risks.\993\ For example, swaps positions held primarily for

    the purpose of generating profits directly upon closeout of the swap,

    and not to hedge or mitigate underlying commercial risk, are

    speculative or serve as investments. Further, as an alternative

    example, swaps executed for the purpose of offsetting potential future

    increases in the price of inputs that the entity reasonably expects to

    purchase for its commercial activities serve to hedge a commercial

    risk.

    ---------------------------------------------------------------------------

    \993\ The Commissions note that the SEC interprets the

    availability of the hedging exclusion differently in the context of

    the ``major security-based swap participant'' definition, and that

    the SEC's guidance in this area controls for purposes of that

    definition.

    ---------------------------------------------------------------------------

    The CFTC notes that the use of ``trading'' in this context is not

    used to mean simply buying and selling. Rather, a party is using a swap

    for the purpose of trading under the rule when the party is entering

    and exiting swap positions for purposes that have little or no

    connection to hedging or mitigating commercial risks incurred in the

    ordinary course of business. ``Trading,'' as used in CFTC Regulation

    Sec. 1.3(kkk)(2)(i), therefore would not include simply the act of

    entering into or exiting swaps if the swaps are used for the purpose of

    hedging or mitigating commercial risks incurred in the ordinary course

    of business.\994\

    ---------------------------------------------------------------------------

    \994\ The CFTC further clarifies that merchandising activity in

    the physical marketing channel qualifies as commercial activity,

    consistent with the Commission's longstanding bona fide hedging

    exemption to speculative position limits. See Sec. 1.3(kkk)(1)(ii).

    ---------------------------------------------------------------------------

    [[Page 30677]]

    The CFTC acknowledges that some swaps that may be characterized as

    ``arbitrage'' transactions in certain contexts may also reduce

    commercial risks enumerated in CFTC Regulation Sec. 1.3(kkk)(1). The

    discussion in footnote 128 of the Proposing Release was intended to

    focus on clarifying that swaps are speculative for purposes of the rule

    if entered into principally and directly for profit and not principally

    to hedge or mitigate commercial risk. The reference to ``arbitrage

    profits'' in footnote 128 was intended to provide an example of what is

    commonly a speculative swap, not to characterize all arbitrage swaps as

    speculative.

    c. ``Economically Appropriate'' Standard

    The CFTC has determined to adopt the ``economically appropriate''

    standard as proposed. We believe that this standard will help the CFTC

    and market participants distinguish which swaps are, or are not,

    commercial hedges thereby reducing regulatory uncertainty and helping

    prevent abuse of the hedging exclusion. CFTC Regulation 1.3(kkk)(1)(i)

    of the final rules enumerates specific risk shifting practices that are

    deemed to qualify for purposes of the hedging exclusion.\995\ Whether a

    swap is economically appropriate to the reduction of risks will be

    determined by the facts and circumstances applicable to the swap at the

    time a swap is entered into. While we acknowledge that this standard

    leaves room for judgment in its application, we believe this

    flexibility is needed given the wide variety of swaps and hedging

    strategies the rule applies to. We believe the economically appropriate

    standard together with the identification of the six different

    categories of permissible commercial risks listed in final CFTC

    Regulation Sec. 1.3(kkk)(1)(i) is specific enough, when reasonably

    applied, to distinguish whether a swap is being used to hedge or

    mitigate commercial risk.

    ---------------------------------------------------------------------------

    \995\ In the alternative to meeting the requirements of CFTC

    Regulation Sec. 1.3(kkk)(1)(i), a swap may also be eligible for the

    hedging exclusion if the swap qualifies as a bona fide hedge for

    purposes of an exception from position limits under the CEA as

    provided in CFTC Regulation Sec. 1.3(kkk)(1)(ii), or if it

    qualifies for hedging treatment under FASB Accounting Standards

    Codification Topic 815 or under GASB Statement 53 as provided in

    CFTC Regulation Sec. 1.3(kkk)(1) (iii). Consequently, the universe

    of swaps that can qualify for the hedging exclusion is broader than

    the universe of swaps that qualify as bona fide hedges for purposes

    of an exception from position limits under the CEA as provided in

    CFTC Regulation Sec. 1.3(kkk)(1)(ii).

    ---------------------------------------------------------------------------

    The Commission has determined not to adopt a ``congruence''

    standard because that standard may be too restrictive and difficult to

    use given the range of potential types of swaps and hedging strategies

    available.

    5. Final Rules--``Major Security-Based Swap Participant'' Definition

    Under the Exchange Act

    a. ``Economically Appropriate'' Standard

    The final rules retain the proposed ``economically appropriate''

    standard, by which a security-based swap position that is used for

    hedging purposes \996\ would be eligible for exclusion from the first

    major participant analysis if the position is economically appropriate

    to the reduction of risks in the conduct and management of a commercial

    enterprise, when those risks arise from the potential change in the

    value of assets, liabilities and services in connection with the

    ordinary course of business of the enterprise.\997\

    ---------------------------------------------------------------------------

    \996\ In the Proposing Release we stated that we did not believe

    the use of the term ``mitigating'' in the exclusion to mean

    something significantly more than ``hedging.'' See Proposing

    Release, 75 FR 80194 n.127. As noted above, some commenters

    disagreed, and argued that ``mitigating'' should be interpreted more

    broadly to encompass general risk mitigation strategies. See, e.g.,

    letters from ISDA and CDEU. In our view, the final rules we are

    adopting--including the use of ``economically appropriate''

    standards and the exclusions for certain positions--encompass

    positions that may reasonably be described as ``hedging'' or

    ``mitigating'' commercial risk.

    \997\ Exchange Act rule 3a67-4(a)(1). Under this standard, the

    first major participant analysis need not account for security-based

    swap positions that pose limited risk to the market and to

    counterparties because the positions are substantially related to

    offsetting risks from a person's commercial operations. These

    hedging positions would include activities, such as the management

    of receivables, that arise out of the ordinary course of a person's

    commercial operations, including activities that are incidental to

    those operations. See Proposing Release, 75 FR at 80195.

    In addition, the security-based swap positions included within

    the rule would not be limited to those recognized as hedges for

    accounting purposes. See id.

    ---------------------------------------------------------------------------

    Consistent with the Proposing Release, we interpret the concept of

    ``economically appropriate'' to mean that the security-based swap

    position cannot materially over-hedge the underlying risk such that it

    could reasonably have a speculative effect,\998\ and that the position

    cannot introduce any new basis risk or other type of risk (other than

    counterparty risk that is attendant to all security-based swaps) more

    than reasonably is necessary to manage the identified risks.

    ---------------------------------------------------------------------------

    \998\ In the Proposing Release, we described the ``economically

    appropriate'' standard as excluding positions that introduce ``any

    new material quantum of risks.'' See Proposing Release, 75 FR 80194

    n. 129. The interpretation in this release is consistent with that

    approach, but does not make use of the same ``quantum of risks''

    terminology.

    ---------------------------------------------------------------------------

    For example, a manufacturer that wishes to hedge the risk

    associated with a customer's long-term lease of a product may purchase

    credit protection using a single-name credit default swap on which the

    customer is the reference entity. The credit default swap may be

    excluded from the first major participant analysis even if it is for a

    shorter term than the anticipated duration of the lease so long as the

    use of such a shorter-term instrument is reasonable as a hedge, such as

    due to cost or liquidity reasons.\999\ Also, the credit default swap

    may be excluded from the first major participant test if it hedges an

    amount of risk that is lower than the total amount of risk associated

    with the long-term contract.\1000\

    ---------------------------------------------------------------------------

    \999\ In other words, the entity may determine that the use of a

    credit default swap for a term that is shorter than the lease is

    justified if that shorter-term instrument costs less or is more

    liquid than a bespoke instrument that matches the duration of the

    contract. While the shorter-term credit default swap does not

    eliminate the underlying commercial risk, the instrument's use may

    be commercially reasonable for hedging purposes, and hence

    appropriately excluded from the first major participant test.

    \1000\ The use of a credit default swap for an amount that is

    smaller than the underlying risk may be justified as part of an

    entity's risk management strategy. For example, an entity may choose

    to engage in a partial hedge because a credit default swap for a

    smaller amount than the underlying risk may cost less or be more

    liquid than a bespoke instrument that more closely matches the

    amount of the risk.

    ---------------------------------------------------------------------------

    In adopting this rule, we have considered commenter views that we

    should consider limiting the exclusion to positions that are recognized

    as hedges for accounting purposes.\1001\ We nonetheless do not believe

    that the requirements that are appropriate to identifying hedging for

    accounting purposes are needed to limit the availability of the hedging

    exclusion. Moreover, linking the availability of the exclusion to

    accounting standards--which themselves may evolve over time--may lead

    the availability of the exclusion to evolve over time in unforeseen

    ways. We accordingly believe that the exclusion should be available if

    a security-based swap position is economically appropriate for hedging

    purposes (and not otherwise precluded from taking advantage of the

    exclusion).

    ---------------------------------------------------------------------------

    \1001\ See letter from Senator Levin.

    ---------------------------------------------------------------------------

    We also have considered commenter concerns that the ``economically

    appropriate'' standard is too broad,\1002\ and the additional

    suggestion that the exclusion instead should be limited to

    circumstances in which the hedge is ``congruent'' to the underlying

    risk.\1003\

    ---------------------------------------------------------------------------

    \1002\ See letters from AFR and AFSCME.

    \1003\ See letter from Better Markets I. We nonetheless do not

    believe that such a requirement would be consistent with the

    exclusion's ``commercial risk'' terminology or underlying intent. A

    congruence standard particularly would not appear to adequately

    reflect the fact that commercially reasonable hedging activities can

    leave residual basis risk.

    ---------------------------------------------------------------------------

    [[Page 30678]]

    We recognize the significance of commenters' concerns as to the

    practical application of the ``economically appropriate'' standard,

    particularly with regard to hedges that are not perfectly correlated

    with the underlying risk.\1004\ The standard embeds principles of

    commercial reasonableness that should assuage those implementation

    concerns, however. These principles necessarily account for the fact

    that the reasonable use of security-based swaps to hedge a person's

    commercial risk may result in residual basis risk, and that the mere

    presence of this basis risk should not preclude the availability of the

    exclusion. Moreover, the mere presence of residual basis risk need not

    run afoul of the restriction against materially over-hedging the

    underlying risk, which is instead intended to prevent the hedging

    exclusion from applying to positions that are entered into for

    speculative purposes or that have speculative effect (such as by being

    based on a notional amount that is disproportionate to the underlying

    risk).\1005\

    ---------------------------------------------------------------------------

    \1004\ See letter from SIFMA AMG II.

    \1005\ For example, non-material basis risk or a non-material

    over-hedge may occur due to the use of a standardized instrument. A

    commercial entity may reasonably determine that it is cost effective

    to use a standardized security-based swap to hedge the underlying

    risk, even if use of the standardized instrument introduces non-

    material basis risk or reflects a non-material amount of over-

    hedging compared to what would be the result of using a bespoke

    security-based swap to hedge that risk.

    ---------------------------------------------------------------------------

    We also acknowledge that an ``economically appropriate'' standard

    does not provide the compliance assurance that would accompany

    quantitative tests or safe harbors. Nonetheless, grounding the hedging

    exclusion in principles of commercial reasonableness permits the

    standard to be sufficiently flexible to appropriately address an end-

    user's particular circumstances and hedging needs. Use of an

    ``economically appropriate'' standard also is consistent with the fact

    that entities should be expected to use their reasonable business

    judgment when hedging their commercial risks.

    To provide additional guidance to entities hedging commercial risk,

    moreover, the final rule incorporates examples of security-based swap

    positions that, depending on the applicable facts and circumstances,

    may satisfy the ``economically appropriate'' standard.\1006\ These are:

    ---------------------------------------------------------------------------

    \1006\ Exchange Act rule 3a67-4(a)(2). We previously noted that

    the proposed definition would facilitate those types of security-

    based swap positions. See Proposing Release, 75 FR at 80196.

    ---------------------------------------------------------------------------

    Positions established to manage the risk posed by a

    customer's, supplier's or counterparty's potential default in

    connection with: financing provided to a customer in connection with

    the sale of real property or a good, product or service; a customer's

    lease of real property or a good, product or service; a customer's

    agreement to purchase real property or a good, product or service in

    the future; or a supplier's commitment to provide or sell a good,

    product or service in the future.\1007\

    ---------------------------------------------------------------------------

    \1007\ As discussed in the Proposing Release, see 75 FR at 80196

    n.135, the references here to customers and counterparties do not

    include swap or security-based swap counterparties.

    ---------------------------------------------------------------------------

    Positions established to manage the default risk posed by

    a financial counterparty (different from the counterparty to the

    hedging position at issue) in connection with a separate transaction

    (including a position involving a credit derivative, equity swap, other

    security-based swap, interest rate swap, commodity swap, foreign

    exchange swap or other swap, option, or future that itself is for the

    purpose of hedging or mitigating commercial risk pursuant to the rule

    or the counterpart rule under the Commodity Exchange Act);

    Positions established to manage equity or market risk

    associated with certain employee compensation plans, including the risk

    associated with market price variations in connection with stock-based

    compensation plans, such as deferred compensation plans and stock

    appreciation rights;

    Positions established to manage equity market price risks

    connected with certain business combinations, such as a corporate

    merger or consolidation or similar plan or acquisition in which

    securities of a person are exchanged for securities of any other person

    (unless the sole purpose of the transaction is to change an issuer's

    domicile solely within the United States), or a transfer of assets of a

    person to another person in consideration of the issuance of securities

    of such other person or any of its affiliates;

    Positions established by a bank to manage counterparty

    risks in connection with loans the bank has made; and

    Positions to close out or reduce any of the positions

    addressed above.

    b. Treatment of Speculative or Trading Positions

    The final rule, consistent with the proposal, provides that this

    hedging exclusion does not extend to security-based swap positions that

    are in the nature of speculation or trading.\1008\ The exclusion thus

    does not extend to security-based swap positions that are held for

    short-term resale and/or with the intent of benefiting from actual or

    expected short-term price movements or to lock in arbitrage profits, or

    to security-based swap positions that hedge other positions that

    themselves are held for the purpose of speculation or trading.\1009\

    ---------------------------------------------------------------------------

    \1008\ Exchange Act rule 3a67-4(b)(1). The commercial risk

    hedging exclusion for the purposes of the ``major security-based

    swap participant'' definition (in contrast to the commercial risk

    hedging exclusion in connection with the ``security-based swap

    dealer'' definition) does not turn upon whether a position is

    ``primarily'' for speculative or trading purposes. For the ``major

    security-based swap participant'' definition, a security-based swap

    position with any speculative or trading purpose cannot take

    advantage of the commercial risk hedging exclusion regardless of

    whether speculation or trading constitutes the ``primary'' purpose

    of the position.

    \1009\ See generally Basel Committee on Banking Supervision,

    ``International Convergence of Capital Measurement and Capital

    Standards, A Revised Framework, Comprehensive Version'' (June 2006)

    at ]] 685-689(iii) (defining the term ``trading book'' for purposes

    of international bank capital standards, and stating that positions

    that are held for short-term resale and/or with the intent of

    benefiting from actual or expected short-term price movements or to

    lock in arbitrage profits are typically considered part of an

    entity's trading book).

    In contrast to the CEA rule implementing the commercial risk

    hedging definition in the context of the ``major swap participant''

    definition, the Exchange Act rule does not explicitly exclude

    security-based swaps held for the purpose of investing. We note,

    however, that security-based swaps held for the purpose of investing

    (i.e., held primarily to obtain an appreciation in value of the

    security-based swap position) would not meet the ``economically

    appropriate'' standard set forth above, and hence would not be

    eligible for the exclusion.

    ---------------------------------------------------------------------------

    The Commissions recognize that some commenters take the position

    that the exclusion should extend to security-based swap positions that

    hedge speculative or trading positions.\1010\ In support, these

    commenters have stated that the proposed approach would lead to more

    unhedged risk in the market, and that the proposed approach could lead

    entities that use security-based swaps to hedge speculative positions

    to be major participants, in contrast to unhedged (and presumably

    riskier) entities. Commenters further requested clarification regarding

    how entities may distinguish speculative or trading positions from

    other security-based swap positions.\1011\

    ---------------------------------------------------------------------------

    \1010\ See, e.g., letters from FSR I and ISDA I.

    \1011\ See, e.g., letter from CDEU.

    ---------------------------------------------------------------------------

    The Commissions nonetheless do not believe that it would be

    appropriate to extend the hedging exclusion to speculative or trading

    positions, including security-based swap positions that themselves

    hedge other positions that are for speculative or trading

    [[Page 30679]]

    purposes. Those limitations are appropriate to help give meaning to the

    concept of ``commercial'' risk, and to reflect the legislative intent

    to limit the impact of Title VII on commercial end-users of security-

    based swaps.\1012\ Indeed, the use of security-based swap positions in

    connection with speculative and trading activity often may be expected

    either to have the purpose of locking-in arbitrage profits associated

    with those activities or producing an adjusted risk profile in

    connection with perceptions of future market behavior--neither of which

    would eliminate the speculative or trading purpose of the

    activity.\1013\ We do not believe that it would be appropriate, or

    consistent with the Dodd-Frank Act, to interpret the term ``commercial

    risk'' to accord the same regulatory treatment to security-based swap

    positions for speculative or trading purposes as is accorded to the use

    of security-based swap positions in connection with commercial

    activities such as producing goods or providing services to

    customers.\1014\

    ---------------------------------------------------------------------------

    \1012\ In addition, this limitation is consistent with the

    exclusion from the first major participant test in connection with

    ERISA plans. That exclusion particularly addresses security-based

    swap positions with the primary purpose of ``hedging or mitigating

    any risk directly associated with the operation of the plan.'' It is

    not clear why that scope of the ERISA exclusion would need to be

    incorporated into the first major participant test if the

    ``commercial risk'' exclusion already were broad enough to encompass

    hedges of trading or speculative positions.

    \1013\ As an example, one speculative/trading strategy involving

    security-based swaps can be to purchase short-dated credit

    protection in conjunction with a long-dated bond, to reflect a view

    that a particular company is likely to fail in the current credit

    environment. Combined, those positions can produce losses if the

    current credit environment did not change or if spreads were to

    widen, but could produce profits either if the company were to

    default or if spreads were to narrow and funding costs were to

    decrease. See Morgan Stanley, Credit Derivatives Insights 156-58

    (4th ed., 2008). In other words, under that strategy the purchase of

    the credit protection would offset a portion of the risks associated

    with the ownership of the bond, but for the purpose of taking a

    directional view of the market with the hope for profit if the

    purchaser's view of future market dynamics is correct (and the

    reality of losses if the purchaser's view of the market is wrong).

    It would require an extraordinarily liberal construction of

    ``commercial risk'' to subsume this type of speculative security-

    based swap activity.

    At the same time, we recognize that an entity hedging a

    commercial risk (in contrast to a risk arising from a speculative or

    trading strategy) reasonably may choose to use a security-based swap

    that is shorter-dated than the underlying risk, with the security-

    based swap appropriately excluded from the first major participant

    definition.

    \1014\ This approach does not reflect any value judgment about

    the role of speculation in the market for security-based swaps, or

    about the relative market benefits or risks associated with

    speculation. This position simply represents an attempt to give

    meaning to the statutory use of the term ``commercial risk'' in a

    way that reflects Title VII's special treatment of commercial end-

    users, and (as discussed below) avoid an interpretation that

    effectively undermines the first major participant test.

    ---------------------------------------------------------------------------

    Moreover, the Commissions believe that it would undermine the major

    participant definition to attribute a non-speculative or non-trading

    purpose to security-based swap positions that hedge speculative or

    trading positions. When a person uses a security-based swap position to

    help lock in profits or otherwise control the volatility associated

    with speculative or trading activity, or to cause that speculative or

    trading activity to reflect a particular market outlook or risk

    profile, the security-based swap position serves as an integral part of

    that speculative or trading activity. It thus would not appear

    appropriate or consistent with economic reality to seek to distinguish

    the security-based swap component from the other speculative or trading

    aspects of that activity. In fact, if ``hedges'' of speculative or

    trading positions were excluded from the first major participant test,

    entities could readily label a wide range of security-based swap

    positions entered into for speculative or trading purposes as being

    excluded hedges.\1015\ Taken to its natural conclusion, such an

    approach largely may exclude security-based swap positions from the

    first major participant test, effectively writing that test out of the

    statutory definition.

    ---------------------------------------------------------------------------

    \1015\ As noted by one participant to the roundtable on these

    definitions: ``[B]eing a hedge fund manager, there's nothing in my

    portfolio I can't claim to be hedging a risk. There's nothing.

    There's not a trade I do ever that I can't claim it to be a hedge

    against interest rates, or inflation, or against equity. You know,

    the fact of the matter is, if you're a capital market participant,

    your business is taking risks.'' Roundtable Transcript at 325

    (remarks of Michael Masters, Better Markets).

    ---------------------------------------------------------------------------

    We are aware of commenters' views that regulation of major

    participants has the potential to create a disincentive against certain

    entities' use of security-based swaps to manage risk in connection with

    their speculative or trading activities.\1016\ Under this view,

    regulation potentially could result in those entities electing not to

    reduce the risks that they otherwise would seek to hedge, to avoid

    being regulated as major participants.\1017\ That potential result,

    however, is an unavoidable consequence of the legislative decision to

    regulate persons whose security-based swap positions cause them to be

    major participants. It would not be appropriate to use the hedging

    exclusion to negate part of the underlying statutory definition simply

    to avoid disincentives that are an unavoidable consequence of the

    legislative decision to regulate major participants.

    ---------------------------------------------------------------------------

    \1016\ See letter from ISDA I.

    \1017\ Of course, this would only be the case where the entity's

    hedging and speculative activities combined were at a level in

    excess of the major participant thresholds.

    ---------------------------------------------------------------------------

    At the same time, we are mindful that market participants have

    requested further guidance as to how to distinguish between hedging

    positions that are subject to this exclusion, and speculative or

    trading positions that fall outside the exclusion. In our view,

    analysis of this issue is simplified by the nature of security-based

    swaps, and by the limited circumstances in which a person may be

    expected to have a commercial risk such that the use of a security-

    based swap may be economically appropriate for managing that commercial

    risk (rather than being for speculation or trading purposes).

    In the case of security-based swaps that are credit derivatives,

    the final rule provides examples of the use of credit default swaps to

    purchase credit protection that, depending on the applicable facts and

    circumstances, may appropriately be excluded from the first major

    participant test (e.g., the use of a credit default swap to purchase

    credit protection in connection with the potential default of a

    customer, supplier or counterparty, or in connection with loans made by

    a bank). Certain other purchases of credit protection using credit

    default swaps--such as the purchase of credit protection to manage the

    risks associated with securities that a non-financial company holds in

    a corporate treasury and that are not held for speculative or trading

    purposes--may also meet the standard under these rules.\1018\ The sale

    of offsetting credit protection may also reasonably be expected to fall

    within the exclusion to the extent that this sale is reasonably

    necessary to address changes (particularly reductions) in the amount of

    underlying commercial risk hedged by the initial security-based swap

    position.\1019\

    ---------------------------------------------------------------------------

    \1018\ This is not to say that the purchase of credit protection

    on a security that a person owns would necessarily be entitled to

    the hedging exclusion. If the underlying security itself is held for

    speculative or trading purposes, the credit protection would not be

    excluded from the first major participant analysis, and in any event

    would not reasonably be construed as hedging ``commercial risk.''

    \1019\ Apart from that example, it is more difficult to foresee

    circumstances in which the sale of credit protection using a credit

    default swap would be expected to fall within the exclusion. We

    recognize, for example, that a person that has a short position in a

    security of a reference entity may have an incentive to sell credit

    protection on that reference entity to offset movements in the price

    or value of that short position (and/or lock in arbitrage profits in

    connection with that short position). While that sale of credit

    protection may mitigate the risks associated with that short

    position, or produce an arbitrage profit in connection with that

    short position, that security-based swap position would not appear

    to constitute the hedging of ``commercial risk'' for purposes of the

    exclusion.

    ---------------------------------------------------------------------------

    [[Page 30680]]

    As for security-based swaps that are not credit derivatives--such

    as equity swaps and total return swaps--the final rule provides

    examples of how the use of those security-based swaps in connection

    with certain business combinations may, depending on the applicable

    facts and circumstances, appropriately be excluded from the first major

    participant test. The use of equity swaps or total return swaps to

    manage the risks associated with securities that are held in a

    corporate treasury (and that are not held for speculative or trading

    purposes) may also appropriately be subject to the exclusion. Other

    uses of equity swaps or total return swaps to offset risks associated

    with long or short positions in securities, however, may not

    appropriately be excluded from the first major participant test,

    because such positions would be expected to have an arbitrage purpose

    or other speculative or trading purpose, and would be inconsistent with

    the ``commercial risk'' limitation to the hedging exclusion.

    c. Treatment of Positions That Hedge Other Swap or Security-Based Swap

    Positions

    The final rule, consistent with the proposal, provides that the

    hedging exclusion does not extend to a security-based swap position

    that hedges another swap or security-based swap position, unless that

    other position itself is held for the purposing of hedging or

    mitigating commercial risk.\1020\ This provision allows the first major

    participant analysis to exclude a person's purchase of credit

    protection to help address the risk of default by a counterparty in

    connection with an interest rate swap, foreign exchange swap or other

    swap or security-based swap that the person has entered into for the

    purpose of hedging or mitigating commercial risk.

    ---------------------------------------------------------------------------

    \1020\ Exchange Act rule 3a67-4(b)(2).

    ---------------------------------------------------------------------------

    d. Procedural Conditions

    In contrast to the proposal, the final rule does not incorporate

    procedural requirements in connection with the hedging exclusion from

    the first test of the major security-based swap participant

    definition.\1021\ In making this change, we have been mindful of

    concerns that have been expressed that such procedural requirements

    would lead to undue costs in connection with hedging activity.\1022\

    ---------------------------------------------------------------------------

    \1021\ Those proposed provisions would have conditioned the

    exclusion on the person identifying and documenting the underlying

    risks, establishing and documenting a method of assessing the hedge

    effectiveness, and regularly assessing the effectiveness of the

    security-based swap as a hedge. See proposed Exchange Act rule 3a67-

    4(c).

    \1022\ See, e.g., letter from FSR I.

    ---------------------------------------------------------------------------

    We understand, however, that many entities engaging in legitimate

    hedging of commercial risks do, as a matter of business practice,

    identify and document those risks and evaluate the effectiveness of the

    hedge from time to time. The presence of supporting documentation

    consistent with such procedures would help support a person's assertion

    that a security-based swap position should be excluded from the first

    major participant analysis, should the legitimacy of the exclusion

    become an issue.

    Also, although we are not requiring the entity to monitor the

    effectiveness of the hedge over time, that absence of this requirement

    does not change the underlying need for a security-based swap position

    to be economically appropriate for the commercial risks facing the

    entity to be excluded from the first major participant definition.

    Thus, for example, if a person's underlying commercial risk materially

    diminishes or is eliminated over time, a security-based swap position

    that may have been economically appropriate to the reduction of risk at

    inception at a certain point in time may, depending on the facts and

    circumstances, no longer be reasonably included within the

    exclusion.\1023\ As part of the reports required in connection with

    possible future changes to the major participant definitions,\1024\ the

    staffs are directed to address whether the continued availability of

    the hedging exclusion should be conditioned on assessment of hedging

    effectiveness and related documentation.

    ---------------------------------------------------------------------------

    \1023\ Factors that may be relevant to determining whether a

    security-based swap position is economically appropriate to the

    reduction of risk may include the costs associated with terminating

    or reducing that position.

    \1024\ See part V, infra.

    ---------------------------------------------------------------------------

    D. Exclusion for Positions Held by Certain Plans Defined Under ERISA

    1. Proposed Approach

    The first statutory test of the major participant definitions

    excludes swap and security-based swap positions that are ``maintained''

    by any employee benefit plan as defined in sections 3(3) \1025\ and

    3(32) \1026\ of ERISA ``for the primary purpose of hedging or

    mitigating any risk directly associated with the operation of the

    plan.'' \1027\

    ---------------------------------------------------------------------------

    \1025\ Section 3(3) of Title I of ERISA defines the term

    ``employee benefit plan'' to include ``an employee welfare benefit

    plan or an employee pension benefit plan or a plan which is both an

    employee welfare benefit plan and an employee pension benefit

    plan.'' See 29 U.S.C. 1002(3). The terms ``employee welfare benefit

    plan'' and ``employee pension benefit plan'' are further defined in

    Sections 3(1) and (2) of ERISA. See 29 U.S.C. 1002(1) and (2).

    \1026\ Section 3(32) of Title I of ERISA defines the term

    ``governmental plan'' to mean a plan that the U.S. government, state

    or political subdivision, or agencies and instrumentalities

    establish or maintain for its employees, as well as plans governed

    by the Railroad Retirement Acts of 1935 and 1937, plans of

    international organizations that are exempt from taxation pursuant

    to the International Organizations Immunities Act, and certain plans

    established and maintained by tribal governments or their

    subdivisions, agencies or instrumentalities. See 29 U.S.C. 1002(32).

    \1027\ CEA section 1a(33)(A)(i)(I); Exchange Act section

    3(a)(67)(A)(ii)(I).

    ---------------------------------------------------------------------------

    The proposed rules incorporated that statutory exclusion without

    additional interpretation or refinement.\1028\ In the Proposing

    Release, moreover, the Commissions expressed the preliminary view that

    we did not ``believe that it is necessary to propose a rule to further

    define the scope of this exclusion.'' We further noted that the

    exclusion for those plans identified in the statutory definition is not

    strictly limited to ``commercial'' risk, and that this may be construed

    to mean that hedging by those ERISA plans should be broadly excluded.

    The Commissions also solicited comment as to whether this exclusion

    should be made available to additional types of entities.\1029\

    ---------------------------------------------------------------------------

    \1028\ See proposed CFTC Regulation Sec. 1.3(hhh)(1)(ii)(A);

    proposed Exchange Act rule 3a67-1(a)(2)(i).

    \1029\ See Proposing Release, 75 FR at 80201, supra.

    ---------------------------------------------------------------------------

    2. Commenters' Views

    Some commenters requested clarification that the ERISA hedging

    exclusion is broader than the commercial risk hedging exclusion, and

    that the ERISA hedging exclusion can encompass positions that are not

    solely for hedging purposes.\1030\ One

    [[Page 30681]]

    commenter cautioned against interpreting the ERISA hedging exclusion

    broadly.\1031\

    ---------------------------------------------------------------------------

    \1030\ See letters from BlackRock I (noting that the ERISA

    hedging exclusion applies to positions with the ``primary purpose''

    of hedging, ``which suggests plans may exclude swap positions even

    if they serve a purpose in addition to hedging or mitigating''), the

    ERISA Industry Committee (``ERISA Industry Committee'') (stating

    that if ERISA Title I plans are not excluded from the major

    participant definition, the rules should clarify that the ERISA

    hedging exclusion is broader than the commercial hedging exclusion

    and encompasses a variety of risks associated with the value of a

    plan's assets or the measures of its liabilities; also stating that

    the ERISA exclusion should not omit positions in the nature of

    investing, and particularly discussing the use of swaps to provide

    diversification), ABC/CIEBA (expressing the view that the ERISA

    hedging exclusion extends beyond ``traditional'' hedges, and stating

    that the exclusion should encompass swaps with purposes in addition

    to hedging, and that the exclusion should encompass positions for

    the purpose of rebalancing, diversification and gaining asset class

    exposure) and CalSTRS I (requesting that regulations provide for an

    ERISA hedging exclusion that is broader than the commercial risk

    hedging exclusion, and that encompasses positions for the purpose of

    investing).

    One commenter alluded to the incorporation of efficient

    portfolio theory principles within the exception. See letter from

    Russell Investments.

    \1031\ See letter from AFSCME (stating that while the statutory

    exclusion may encompass swaps to mitigate currency risk of cash

    market investments, the exclusion should not encompass swaps used

    for investment purposes such as to gain asset class exposure or

    avoid transaction costs associated with a direct investment).

    ---------------------------------------------------------------------------

    Commenters also requested that the Commissions clarify that the

    ERISA hedging exclusion applies to positions maintained by trusts that

    hold plan assets,\1032\ or by pooled funds.\1033\ One commenter, in

    contrast, stated that the exclusion should not be available to trusts

    holding plan assets.\1034\

    ---------------------------------------------------------------------------

    \1032\ See letters from ERISA Industry Committee (stating that

    the rules should provide that the exclusion applies to positions

    maintained by any trust holding plan assets) and ABC/CIEBA (stating

    that the rules should provide the relevant entity for purposes of

    the exclusion is the counterparty to the swap, further stating that

    if a trust enters into a swap as a counterparty, it is the trust

    that should be tested as a possible major participant, even if the

    trust also holds non-ERISA assets).

    \1033\ See letters from BlackRock I (discussing how plan

    fiduciaries may invest plan assets ``in pooled investment vehicles

    such as registered investment companies, private funds and bank

    maintained collective trust funds,'' and stating that not including

    pooled funds within the exclusion would limit plans' ability to

    avail themselves of the efficiencies associated with pooling), ERISA

    Industry Committee (stating that there is ``no reason'' why the

    exception should not also extend to position held by a pooled

    investment trust on behalf of multiple employee benefit plans) and

    ABC/CIEBA (stating that if a pool within a trust is the

    counterparty, it is that pool that should be tested as a possible

    major participant, and noting Department of Labor regulations

    providing that a collective investment vehicle would be viewed as

    holding plan assets if the vehicle is not a registered investment

    company, and plans hold at least 25 percent of the interests in the

    vehicle).

    \1034\ See letter from AFSCME (stating that ``it is important to

    limit the exemption to plans themselves, not to entities holding

    `plan assets' '').

    ---------------------------------------------------------------------------

    One commenter stated that the exception should be extended to all

    public pension plans,\1035\ and one commenter particularly took the

    view that the exclusion should be available to church plans.\1036\ Some

    commenters stated that the exclusion should be available to non-U.S.

    plans.\1037\

    ---------------------------------------------------------------------------

    \1035\ See letter from Russell Investments.

    \1036\ See letter from Church Alliance (stating that the

    exclusion also should encompass church plans defined in paragraph

    3(33) of ERISA, on the grounds that Congress would not have intended

    to discriminate against church plans, and that church plans are

    considered ``special entities'' that should be the beneficiaries of

    extra protection).

    \1037\ See letters from ABC/CIEBA, APG and BTPS.

    The Commissions intend to issue separate releases that address

    the application of the major participant definitions, and Title VII

    generally, to non-U.S. entities.

    ---------------------------------------------------------------------------

    3. Final Rules

    Consistent with the position expressed in the Proposing Release,

    the Commissions interpret the ERISA hedging exclusion in the first

    statutory major participant test to be broader than that test's

    commercial risk hedging exclusion. This reflects the facts that the

    ERISA hedging exclusion is not limited to ``commercial'' risk, and that

    the ERISA hedging exclusion addresses positions that have a ``primary''

    hedging purpose (which suggests that those positions may have a

    secondary non-hedging purpose).

    a. Types of Excluded Hedging Activities

    The Commissions are mindful of commenters' request for additional

    clarity regarding the scope of the ERISA hedging exclusion. In that

    regard, we note that we generally would expect swap or security-based

    swap positions to have a primary purpose of hedging or mitigating risks

    directly associated with the operation of the types of plans identified

    in the statutory definition--and hence eligible for the exclusion--when

    those positions are intended to reduce disruptions or costs in

    connection with, among others, the anticipated inflows or outflows of

    plan assets, interest rate risk, and changes in portfolio management or

    strategies.

    Conversely, we believe that certain other types of positions would

    less likely have the primary purpose of hedging or mitigating risks

    directly associated with the operation of the plan, as anticipated by

    the statutory definition.\1038\

    ---------------------------------------------------------------------------

    \1038\ For example, we do not foresee that the use of a swap or

    security-based swap position to replicate exposure to a foreign

    market or to a particular asset class to be for the primary purpose

    of hedging risks directly associated with the operation of these

    types of plans. While we recognize that an asset manager may

    perceive benefits in using swaps or security-based swaps in that

    manner, it also is necessary to give effect to the statutory

    language limiting the exclusion to positions that have a ``primary

    purpose'' of hedging risks ``directly associated'' with the

    ``operations'' of a plan. We recognize that lack of diversification

    may be viewed as a risk, but it is not an ``operations'' risk.

    ---------------------------------------------------------------------------

    b. Availability of Exclusion

    The Commissions recognize the significance of comments that these

    plans may use separate entities such as trusts or pooled vehicles to

    hold plan assets, and that the exclusion should not be interpreted in a

    way that deters the use of those vehicles. We believe that the same

    principles that underpin the exclusion for hedging positions directly

    entered into by the types of plans identified in the statutory

    definition also warrant making the exclusion applicable to plan hedging

    positions that are entered into by those other parties that hold assets

    of those types of plans. Otherwise, the major participant analysis

    would have the effect of deterring efficiencies in plan operations for

    no apparent regulatory purpose.

    Accordingly, the Commissions interpret the meaning of the term

    ``maintain''--in the context of the statutory provision that the swap

    or security-based swap position be ``maintained by'' an employee

    benefit plan--not only to include positions in which the plan is a

    counterparty, but also to include positions in which the counterparty

    is a trust or pooled vehicle that holds plan assets. Thus, for example,

    the exclusion would be available to trusts or pooled vehicles that

    solely hold assets of the types of plans identified in the statutory

    definition.\1039\ The exclusion further may be available to entities

    that hold such plan assets in conjunction with other assets, but only

    to the extent that the entity enters into swap or security-based swap

    positions for the purpose of hedging risks associated with the plan

    assets. The exclusion does not extend to positions that hedge risks of

    other assets, even if those are managed in conjunction with plan

    assets.\1040\

    ---------------------------------------------------------------------------

    \1039\ This interpretive guidance is intended solely in the

    context of the interpretation of the first test of the statutory

    major participant definitions. The guidance is not based on or

    relevant to the interpretation of other regulations relating to

    ERISA.

    \1040\ As appropriate, for purposes of the first major

    participant analysis an entity may need to allocate the exposure

    associated with swap or security-based swap positions between the

    amount that is attributable to plan assets (and hence eligible for

    exclusion) and the amount that is attributable to other assets.

    ---------------------------------------------------------------------------

    The Commissions also are mindful of commenter concerns that the

    exclusion should explicitly be made available to other plans, such as

    church plans and non-U.S. plans.\1041\ In this regard, the Commissions

    believe that the boundaries of the exclusion are set by the explicit

    statutory language, which states that it applies to any employee

    benefit plan as defined in paragraphs (3) and (32) of section 3 of

    ERISA. This reference is disjunctive--that is, a plan is eligible for

    the exclusion if it is within the scope of paragraph (3) (which refers

    to employee benefit plans)

    [[Page 30682]]

    or of paragraph (32) (which applies to government plans). Accordingly,

    the scope of the cited definitions in paragraphs (3) and (32) should be

    determined in accordance with all law that applies in the

    interpretation of ERISA.\1042\

    ---------------------------------------------------------------------------

    \1041\ As previously noted, the Commissions intend to issue

    separate releases that address the application of the major

    participant definitions, and Title VII generally, to non-U.S.

    entities.

    \1042\ We are not taking a view as to whether church plans or

    non-U.S. plans constitute employee benefit plans as defined by

    section 3(3) of ERISA.

    ---------------------------------------------------------------------------

    E. ``Substantial Counterparty Exposure''

    1. Proposed Approach

    The major participant definitions' second statutory test

    encompasses persons whose outstanding swaps or security-based swaps

    ``create substantial counterparty exposure that could have serious

    adverse effects on the financial stability of the U.S. banking system

    or financial markets.'' \1043\ In contrast to those definitions' first

    statutory test, which relates to persons with a ``substantial

    position'' in swaps or security-based swaps in a ``major''

    category,\1044\ this second test is not limited to positions in a

    single category. Also, unlike the first test, the second statutory test

    does not explicitly exclude certain commercial risk hedging positions

    or ERISA hedging positions.

    ---------------------------------------------------------------------------

    \1043\ CEA section 1a(33)(A)(ii); Exchange Act section

    3(a)(67)(A)(ii)(II).

    \1044\ CEA section 1a(33)(A)(i); Exchange Act section

    3(a)(67)(A)(ii)(I).

    ---------------------------------------------------------------------------

    For the ``major swap participant'' definition, the Proposing

    Release provided that a person's swap positions pose ``substantial

    counterparty exposure'' if those positions present a daily average

    current uncollateralized exposure of $5 billion or more, or present

    daily average current uncollateralized exposure plus potential future

    exposure of $8 billion or more.\1045\ For the ``major security-based

    swap'' definition, the proposal provided that a person's security-based

    swap positions pose ``substantial counterparty exposure'' if those

    positions present daily average current uncollateralized exposure of $2

    billion or more, or present daily average current uncollateralized

    exposure plus potential future exposure of $4 billion or more.\1046\

    ---------------------------------------------------------------------------

    \1045\ See proposed CFTC Regulation Sec. 1.3(lll).

    \1046\ See proposed Exchange Act rule 3a67-5.

    ---------------------------------------------------------------------------

    Under the proposal, those measures would be calculated in the same

    manner as would be used for the first major participant test, except

    that the ``substantial counterparty exposure'' analysis would consider

    all of a person's swap or security-based swap positions rather than

    solely considering positions in a particular ``major'' category, and

    that the ``substantial counterparty exposure'' analysis would not

    exclude positions to hedge commercial risks or ERISA plan risks.

    The proposed ``substantial counterparty exposure'' thresholds were

    set higher than the proposed ``substantial position'' thresholds in

    part to reflect the fact that the former test accounts for a person's

    positions across four major swap categories or two major security-based

    swap categories.\1047\ The proposed ``substantial counterparty

    exposure'' thresholds also reflected the fact that this second test

    (unlike the first major participant test) encompasses certain hedging

    positions that, in general, we would expect to pose a lesser degree of

    risk to counterparties and the markets.

    ---------------------------------------------------------------------------

    \1047\ Thus, these proposed thresholds in part would account for

    a person that has large positions in more than one major category of

    swaps or security-based swaps, but that does not meet the

    substantial position threshold for any single category of swaps or

    security-based swaps.

    ---------------------------------------------------------------------------

    2. Commenters' Views

    a. General Comments

    In light of the similarity between the proposed tests, a number of

    the concerns that commenters expressed with regard to the proposed

    ``substantial position'' definition also apply to the proposed

    ``substantial counterparty exposure'' definition. In addition, some

    commenters took the view that the proposed ``substantial counterparty

    exposure'' thresholds were too low,\1048\ with several of those

    commenters stating that the thresholds should be raised to a level that

    reflects systemic risk.\1049\ A few commenters took the view that the

    proposed thresholds were too high.\1050\ Some commenters generally

    supported the approach to the definition of ``substantial counterparty

    exposure'' proposed by the Commissions.\1051\

    ---------------------------------------------------------------------------

    \1048\ See, e.g., letters from ATAA (supporting higher

    thresholds to measure substantial counterparty exposure), CCMR I

    (suggesting that the thresholds be set high initially, capturing

    only a few entities until the Commissions are able to collect and

    analyze data that supports lowering the thresholds), BG LNG I

    (stating that proposed threshold should be increased substantially),

    WGCEF II (stating that the Commissions should adopt substantial

    position and substantial counterparty exposure tests that account

    for current conditions in swap markets), ABC/CIEBA (requesting that

    the Commissions raise the thresholds to better target persons

    creating or causing systemic risk as set forth in the a major swap

    participant and major security-based swap participant definitions),

    BlackRock I (stating that proposed thresholds for the substantial

    counterparty exposure test are too low so that they could encompass

    market participants that do not have systemically important swap

    positions) and ACLI (supporting increasing the thresholds under the

    CEA definition to $7 billion in daily average aggregate

    uncollateralized outward exposure or $14 billion in daily average

    aggregate uncollateralized outward exposure plus daily average

    aggregate potential outward exposure), and meeting with MFA on

    February 14, 2011 (requesting that the Commissions raise the

    thresholds for measuring substantial counterparty exposure until the

    Commissions conduct a market survey to determine how many entities

    would need to perform the calculations regularly and whether those

    entities have characteristics capable of causing systemic risk).

    \1049\ See letters from ABC/CIEBA, BlackRock I, ISDA I, WGCEF

    II, and meeting with MFA on February 14, 2011.

    \1050\ See letters from Greenberger (in connection with

    thresholds relating to substantial position) and AFR (Commissions

    should define a major swap participant or major security-based swap

    participant as any person that maintains $500 million in daily

    average, uncollateralized exposure for any category of swaps other

    than rate swaps, for which the daily average could be up to $1.5

    billion).

    \1051\ See, e.g., letters from ATAA (supporting the proposed

    definitions of ``substantial position'' and ``substantial

    counterparty exposure,'' with the caveat that higher thresholds be

    used to measure ``substantial counterparty exposure''), Dominion

    Resources (supporting the Commissions proposed definitions of

    ``substantial position'' and ``substantial counterparty exposure''),

    Fidelity (threshold levels set at appropriate levels but should be

    periodically reviewed for adjustment), and Kraft (thresholds as

    proposed are appropriate).

    ---------------------------------------------------------------------------

    Some commenters took the view that the ``substantial counterparty

    exposure'' test should focus on the size of an entity's exposure to

    specific counterparties.\1052\ Several commenters suggested that the

    thresholds should be adjusted over time for inflation and changes in

    the swap and security-based swap markets.\1053\ One commenter urged

    that the analysis consider the interconnectedness of the entity.\1054\

    ---------------------------------------------------------------------------

    \1052\ See letters from MFA (stating that the calculation of

    substantial counterparty exposure should measure the exposure that a

    person has to each individual counterparty that is a systemically

    important financial institution excluding cleared swap transactions)

    and CCMR I (stating that the ``substantial counterparty exposure''

    and ``substantial position'' thresholds should apply to the largest

    exposure that a person has to another market participant, with any

    aggregate test being set at a higher level).

    \1053\ See letters from CDEU, COPE I, Fidelity, ISDA I, and MFA

    I.

    \1054\ See letter from CDEU.

    ---------------------------------------------------------------------------

    One commenter addressed the application of the second major

    participant test to insurance companies, arguing that substantial

    counterparty exposure should be decided by the FSOC in consultation

    with the relevant state insurance commissioner, and that hedges should

    be excluded from the calculation for insurers.\1055\

    ---------------------------------------------------------------------------

    \1055\ See letter from NAIC (stating that the Commissions should

    defer to FSOC when considering the designation of insurers under the

    second test, and should exclude from the analysis swaps and

    security-based swap positions used for hedging provided that such

    positions are subject to state investment laws and ongoing

    monitoring by a state insurance regulatory authority).

    ---------------------------------------------------------------------------

    b. Lack of Exclusion for Hedging Positions

    A number of commenters took the view that the second major

    participant

    [[Page 30683]]

    test should exclude commercial risk hedging positions from the

    analysis.\1056\ Some commenters also supported excluding ERISA hedging

    positions from the analysis.\1057\ One commenter opposed any such

    exclusions for hedging positions.\1058\

    ---------------------------------------------------------------------------

    \1056\ See letters from SIFMA AMG II (noting that the

    Commissions have suggested that hedging positions may not raise the

    same degree of risk as other swap positions), NAIC (supporting

    exclusion of commercial risk hedging positions subject to state

    investment laws and ongoing monitoring by state insurance

    regulators), AIA (supporting hedging exclusion to avoid capturing

    entities such as property-casualty insurers), CDEU (suggesting that

    inclusion of hedging positions is inconsistent with goal of

    mitigating systemic risk), APG (supporting exclusion of positions

    held by regulated foreign pension plans), and NRG Energy (suggesting

    that a lack of an exclusion would cause end-users to curtail hedging

    activities and increase systemic risk); see also letter from AIMA I

    (supporting an exemption or discount if the swap transaction is

    cleared, an off-set for the value and quality of any collateral, and

    consideration of the directional moves of particular swap

    contracts).

    \1057\ See letters from ABC/CIEBA and SIFMA AMG II. One

    commenter further requested that ERISA Title I plans be explicitly

    excluded from the second test. See letter from ERISA Industry

    Committee. Another commenter requested an exclusion for ERISA plans

    generally. See letter from CalSTRS I.

    \1058\ See letter from Better Markets I (stating that excluding

    hedging positions would be inappropriate because the Dodd-Frank Act

    did not provide for any such exclusion in the second test, hedge

    positions may still contribute to counterparty exposure, and the

    thresholds already reflect the lower level of risk posed by hedge

    positions).

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    3. Final Rules

    Consistent with the Proposing Release, the final rules defining the

    term ``substantial counterparty exposure'' generally are based on the

    same current uncollateralized exposure and potential future exposure

    tests that are used to identify a ``substantial position.'' \1059\ As

    with the Proposing Release, moreover, the ``substantial counterparty

    exposure'' analysis addresses all of a person's swap or security-based

    swap positions (rather than being limited to positions in a ``major''

    category), and does not exclude hedging positions.\1060\ The final

    rules also incorporate the quantitative thresholds that were proposed

    for those tests.\1061\

    ---------------------------------------------------------------------------

    \1059\ Accordingly, changes that the final rules made to the

    proposal with regard to the ``substantial position'' definition, see

    part IV.B.3, supra, also are carried over to the definition of

    ``substantial counterparty exposure.''

    \1060\ See CFTC Regulation Sec. 1.3(lll); Exchange Act rule

    3a67-5.

    \1061\ Accordingly, consistent with the proposal, the threshold

    for the ``major swap participant'' definition is $5 billion or more

    in daily average current uncollateralized exposure, or $8 billion or

    more in daily average uncollateralized exposure plus potential

    future exposure. The threshold for the ``major security-based swap

    participant'' is $2 billion or more in daily average current

    uncollateralized exposure, or $4 billion or more in daily average

    uncollateralized exposure plus potential future exposure.

    ---------------------------------------------------------------------------

    In adopting these final rules we have considered commenter views

    that the ``substantial counterparty exposure'' analysis should exclude

    certain commercial risk and ERISA hedging positions. We nonetheless

    believe that the structure of the major participant definitions--

    particularly the fact that those definitions specifically exclude

    hedging positions from the first statutory test but not from the second

    test--necessitates the conclusion that the second test not exclude

    those hedging positions.

    We also have considered commenter views that the ``substantial

    counterparty exposure'' analysis should account for the maximum

    exposure that a person poses to any single counterparty. We nonetheless

    believe that the statutory test--particularly its focus on serious

    adverse effects on financial stability or financial markets--more

    appropriately is addressed by measures of the aggregate counterparty

    risk that an entity poses through its swap or security-based swap

    positions. Also, consistent with our views regarding the ``substantial

    position'' definition, we believe that the ``substantial counterparty

    exposure'' analysis appropriately is addressed via objective and

    quantitative criteria (rather than a multi-tier approach), and

    appropriately takes into account current uncollateralized exposure and

    potential future exposure.

    Consistent with the Proposing Release, the thresholds to implement

    the second major participant test are higher than the corresponding

    thresholds for the first major participant test. These differences

    reflect the fact that the second test encompasses four ``major''

    categories of swaps or two ``major'' categories of security-based

    swaps, as well as the fact that this second test does not exclude

    hedging positions that would appear to pose a lesser degree of

    counterparty risk than non-hedging positions.

    While we are mindful of commenter views that the proposed

    ``substantial counterparty exposure'' thresholds were too low,\1062\ we

    believe that the same principles that support the proposed standards in

    the context of the ``substantial position'' definition also support the

    proposed standards for this second test. As with the ``substantial

    position'' analysis, the ``substantial counterparty exposure'' analysis

    seeks to reflect a standard that encompasses large market participants

    before the counterparty risk posed by their swap and security-based

    swap positions present too large a problem, as well as the financial

    system's ability to absorb losses of a particular size, and the need to

    account for the possibility that multiple market participants may fail

    close in time.\1063\ Commenters have not presented empirical or

    analytical evidence in support of a different standard. In the future,

    the Commissions may review and potentially adjust these thresholds to

    reflect evolving market structures and additional data.

    ---------------------------------------------------------------------------

    \1062\ See notes 1051 and 1052, supra.

    \1063\ As with the ``substantial position'' analysis, our

    decision to adopt these thresholds is informed by events related to

    AIG Financial Products and LTCM. See part IV.B.3.d, supra.

    ---------------------------------------------------------------------------

    F. ``Highly Leveraged'' and ``Financial Entity''

    1. Proposed Approach

    The third statutory test of the major participant definitions

    encompasses any non-dealer that: (i) Is a ``financial entity'' (other

    than one that is ``subject to capital requirements established by an

    appropriate Federal banking agency''), (ii) is ``highly leveraged

    relative to the amount of capital it holds,'' and (iii) maintains a

    ``substantial position'' in any ``major'' category of swaps or

    security-based swaps.\1064\ In contrast to the first statutory test--

    which also encompasses persons with a ``substantial position'' in swaps

    or security-based swaps in a ``major'' category--this third test does

    not exclude positions that hedge commercial risk or ERISA risks.

    ---------------------------------------------------------------------------

    \1064\ CEA section 1a(33); Exchange Act section 3(a)(67).

    ---------------------------------------------------------------------------

    a. ``Financial Entity''

    The Proposing Release defined the term ``financial entity'' for

    purposes of the major participant definition in the same general manner

    as Title VII defines that term for purposes of the end-user exemption

    from mandatory clearing,\1065\ but with certain technical changes to

    avoid circularity.\1066\

    ---------------------------------------------------------------------------

    \1065\ CEA section 2(h)(7); Exchange Act section 3C(g)(3)(A).

    \1066\ See proposed CFTC Regulation Sec. 1.3(mmm)(1); proposed

    Exchange Act rule 3a67-6(a). For both sets of rules, the ``financial

    entity'' definition would include any: commodity pool (as defined in

    section 1a(10) of the CEA); private fund (as defined in section

    202(a) of the Investment Advisers Act of 1940); employee benefit

    plan as defined in paragraphs (3) and (32) of section 3 of ERISA;

    and person predominantly engaged in activities that are in the

    business of banking or financial in nature (as defined in section

    4(k) of the Bank Holding Company Act of 1956).

    To avoid circularity, the use of the term ``financial entity''

    in the context of the ``major swap participant'' definition also

    would encompass any ``security-based swap dealer'' and ``major

    security-based swap participant,'' but would not include any ``swap

    dealer'' or ``major swap participant'' (even though the latter terms

    also are found in the ``financial entity'' definition used for

    purposes of the end-user clearing exception). See proposed CFTC

    Regulation Sec. 1.3(mmm)(1). In the context of the ``major

    security-based swap participant'' definition, the term ``financial

    entity'' also would encompass any ``swap dealer'' or ``major swap

    participant,'' but would not include any ``security-based swap

    dealer'' and ``major security-based swap participant.'' See proposed

    Exchange Act rule 3a67-6(a).

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    [[Page 30684]]

    b. ``Highly Leveraged''

    The Proposing Release set forth two alternative approaches for

    determining whether a particular entity would be deemed ``highly

    leveraged.'' \1067\ Under one approach, an entity would be ``highly

    leveraged'' if the ratio of its liabilities to equity exceeded 8 to 1;

    this proposed alternative reflected the fact that the third statutory

    major participant test excludes certain types of entities.\1068\ Under

    the alternative approach, an entity would be ``highly leveraged'' if

    the ratio of its liabilities to equity exceeded 15 to 1; this proposed

    alternative reflected standards for maximum leverage in certain

    circumstances found in Title I of the Dodd-Frank Act.\1069\ The

    proposal further provided that leverage would be measured at the close

    of business on the last business day of the applicable fiscal quarter,

    and that liabilities and equity would be determined in accordance with

    U.S. generally accepted accounting principles (``GAAP'').\1070\

    ---------------------------------------------------------------------------

    \1067\ See proposed CFTC Regulation Sec. 1.3(mmm)(2); proposed

    Exchange Act rule 3a67-6(b).

    \1068\ The Proposing Release particularly noted that the third

    statutory major participant test excludes financial institutions

    subject to capital requirements set by Federal banking agencies, and

    recognized the possibility those entities were excluded based on the

    presumption that they generally are highly leveraged. The Proposing

    Release noted, based on analysis of financial statements, that it

    appears that those institutions generally have a leverage ratio of

    10 to 1, and that this suggested that the ``highly leveraged''

    threshold would have to be lower for those institutions to

    potentially be subject to the third test. See Proposing Release, 75

    FR at 80199.

    \1069\ The Proposing Release noted that Title I provides that

    the Board must require a bank holding company with total

    consolidated assets equal to or greater than $50 billion, or a

    nonbank financial company supervised by the Board, to maintain a

    debt to equity ratio of no more than 15 to 1 if the FSOC determines

    ``that such company poses a grave threat to the financial stability

    of the United States and that the imposition of such requirement is

    necessary to mitigate the risk that such company poses to the

    financial stability of the United States.'' See Dodd-Frank Act

    section 165(j)(1). The Proposing Release further noted that this 15

    to 1 ratio may represent an upper limit to acceptable leverage and

    that the major participant analysis should use a lower threshold,

    or, alternatively, that the 15 to 1 ratio provides an appropriate

    test of whether an entity poses the systemic risk concerns

    implicated by the major participant definitions. See Proposing

    Release, 75 FR at 80199.

    \1070\ The Proposing Release also stated that entities that file

    quarterly reports on Form 10-Q and annual reports on Form 10-K with

    the SEC would determine their total liabilities and equity based on

    the financial statements included with such filings while all other

    entities would calculate the value of total liabilities and equity

    consistent with the proper application of U.S. GAAP. See id.

    ---------------------------------------------------------------------------

    In proposing these alternative standards for identifying ``highly

    leveraged'' entities, the Commissions recognized that traditional

    balance sheet measures of leverage are limited as tools for evaluating

    an entity's ability to meet its obligations--in part because such

    measures do not directly account for potential risks posed by specific

    instruments held on the balance sheet, or for financial instruments

    held off of the balance sheet. At the same time, the Commissions

    preliminarily concluded that it was not necessary to use more complex

    measures of risk-adjusted leverage for these purposes, in part because

    the third test's ``substantial position'' analysis already accounts for

    such risks. The Commissions also noted the costs that would be

    associated with causing entities to engage in complex calculations of

    risk-adjusted leverage.\1071\

    ---------------------------------------------------------------------------

    \1071\ See id. at 80198-99.

    ---------------------------------------------------------------------------

    The Proposing Release solicited comment on a variety of issues

    related to the proposed leverage ratios, including the relative merits

    of the alternative 8 to 1 and 15 to 1 standards, and potential

    alternative standards.\1072\

    ---------------------------------------------------------------------------

    \1072\ See id. at 80199-200.

    ---------------------------------------------------------------------------

    2. Commenters' Views

    a. ``Financial Entity''

    Some commenters recommended that certain types of entities should

    be excluded from the definition of ``financial entity,'' on the grounds

    that those types of entities are more appropriately treated as non-

    financial end users of swaps for purposes of the Dodd-Frank Act.\1073\

    Commenters specifically suggested that the ``financial entity''

    definition exclude: (i) Centralized hedging and treasury subsidiaries

    in corporate groups; \1074\ (ii) employee benefit plans; \1075\ and

    (iii) cooperative structures.\1076\ Commenters also requested

    clarification as to which entities would not be ``subject to capital

    requirements established by an appropriate Federal banking agency,''

    and hence not subject to the third statutory test.\1077\ In addition,

    commenters addressed the application of the ``financial entity''

    definition to non-U.S. persons.\1078\

    ---------------------------------------------------------------------------

    \1073\ See, e.g., letters from CalSTRS dated June 15, 2011

    (``CalSTRS II''), Kraft, Newedge, NRU CFC I and Philip Morris.

    \1074\ See letters from Kraft and Philip Morris.

    \1075\ See letter from CalSTRS II (asserting that there is not a

    basis to treat ERISA plans as ``financial entities'' for purposes of

    the major participant definitions solely to maintain consistency

    with an ``anomalous'' statutory provision).

    \1076\ See letter from NRU CFC I.

    \1077\ See letters from ACLI (requesting confirmation that the

    exclusion from the third statutory test extends to entities subject

    to bank or financial holding companies, entities deemed systemically

    important under Title I of the Dodd-Frank Act, and any other persons

    subject to capital regulation established by a Federal banking

    regulator) and MetLife (requesting clarification that the exclusion

    extends to persons subject to regulation and capital requirements on

    a consolidated basis under federal banking law, and persons that are

    individually or systemically important financial institutions under

    Title I).

    \1078\ One commenter took the view that non-U.S. governments and

    their agencies should be excluded from the ``financial entity''

    definition for purposes of the major participant definition and the

    Title VII end-user exemption from mandatory clearing. See letter

    from Milbank. On the other hand, one commenter favored the inclusion

    of non-U.S. governments in the ``financial entity'' definition. See

    meeting with Duffie on February 2, 2011 (suggesting that foreign

    governments and other foreign jurisdictions, such as municipalities,

    should be treated as ``financial entities'' for purposes of the

    major swap participant definition and other requirements under the

    Dodd-Frank Act on the grounds that such entities could become

    sources of systemic risk).

    The Commissions intend to issue separate releases addressing the

    application of Title VII to non-U.S. persons.

    ---------------------------------------------------------------------------

    b. ``Highly Leveraged''

    A number of commenters supported the proposed 15 to 1 alternative

    leverage ratio over the 8 to 1 alternative, with some commenters

    further suggesting that the final rule should set a leverage ratio

    higher than 15 to 1, or that the ratio should be reconsidered when more

    information is available regarding leverage among swap users.\1079\ One

    commenter supported the proposed 8 to 1 alternative,\1080\ and one

    commenter

    [[Page 30685]]

    suggested that the final rule should set a leverage ratio lower than 8

    to 1.\1081\ One commenter suggested a ratio of 12 to 1, consistent with

    certain capital requirements.\1082\

    ---------------------------------------------------------------------------

    \1079\ See letters from ISDA I (suggesting that the wide use of

    leverage by financial institutions means that the definition should

    capture only entities with the ``very highest'' leverage ratios, and

    that the 15 to 1 ratio should be viewed as a floor for identifying

    highly leveraged entities given that it is used in Title I to

    address entities that have already been determined to pose a ``grave

    threat'' to the stability of the U.S. financial system), MFA I

    (stating that 15 to 1 is the more appropriate of the two choices,

    and that the Commissions could subsequently adjust the ratio after

    receiving market data on the use of leverage), AIMA I (encouraging

    the Commissions to adopt the 15 to 1 leverage threshold until an

    assessment of the impact of the major participant definitions can be

    completed); Amex (supporting the use of the 15 to 1 ratio, noting

    that it is consistent with the maximum leverage allowed to entities

    designated as a grave threat to financial stability under Title I of

    the Dodd-Frank Act) and CDEU (recommending use of the 15 to 1

    standard, based on its consistency with the leverage limit in Title

    I of the Dodd-Frank Act for entities posing a grave threat to the

    United States financial system and that ``it would be unreasonable

    to propose a stricter leverage threshold under the major participant

    test for nonbank financial end-users,'' and expressing concern that

    entities comfortably falling under the 8 to 1 ratio could

    unexpectedly exceed this threshold during periods of market stress

    and that sudden designation as a major participant ``could seriously

    hinder a company from meeting its obligations'').

    \1080\ See letter from Better Markets I (stating that the 8 to 1

    threshold would better serve the purposes of the Dodd-Frank Act by

    ``ensuring that more, rather than fewer, financial entities are

    covered by the risk mitigation and business conduct standards that

    Congress established'' for major participants, and that use of the

    15 to 1 leverage ratio from Title I of the Dodd-Frank Act is

    inappropriate because the Title I ratio is used for the ``relatively

    draconian'' purpose of imposing leverage limits, while this ratio

    would be used for ``the more modest purpose of imposing registration

    requirements'').

    \1081\ See letter from Greenberger (suggesting that the leverage

    test should be set at a ratio that is lower than either of the two

    proposed levels).

    \1082\ See meeting with MFA on February 14, 2011 (MFA

    representatives making point that ``highly leveraged'' should be

    defined in coordination with other regulations under the Dodd-Frank

    Act, and for example, a requirement that banks hold 8% capital

    implies a leverage ratio of approximately 12:1).

    ---------------------------------------------------------------------------

    Commenters also suggested a variety of methods and adjustments for

    calculating leverage ratios.\1083\

    ---------------------------------------------------------------------------

    \1083\ The suggested adjustments were: to measure the ratio o